2018

A labor force participation rate that is at or above its long-run trend is consistent with a labor market at or above full employment. In 2018, the estimated rate is at its trend of 62.8%, suggesting that the labor market is at full employment. Studying the population’s demographic makeup and labor trends for different groups sheds some light on what is driving the aggregate participation trend and implications for the future. Projections based on these trends estimate that labor participation will decline about 2.5 percentage points over the next decade.

Labor force participation among U.S. men and women ages 25 to 54 has been declining for nearly 20 years, a stark contrast with rising participation in Canada over this period. Three-fourths of the difference between the two countries can be explained by the growing gap in labor force attachment of women. A key factor is the extensive parental leave policies in Canada. If the United States could reverse the trend in participation of prime-age women to match Canada, it would see 5 million additional prime-age workers join the labor force.

The yield spread between long-term and short-term Treasury securities is known to be a good predictor of economic activity, particularly of looming recessions. One way to learn more is through a careful scrutiny of the historical variation of such yield spreads and how they relate to the current slope of the Treasury yield curve. The results suggest that the recent flattening of the yield curve implies only a slightly elevated risk of a recession in the near term relative to any other month.

People’s feelings about the economy have been shown to be strongly connected to a state’s current economic health over short horizons. So, how well do such consumer sentiment measures coincide with economic growth over a longer period? Sentiment shocks are associated with large and statistically significant changes in state economic output over as long as a three-year horizon. While the sentiment shocks initially affect state consumption expenditures to a smaller degree, the impact tends to be more persistent, continuing as long as five years after the initial shock.

U.S. labor force participation by people in their prime working years fell substantially during the Great Recession, and it remains depressed despite some recovery since 2015. This appears to reflect longer-term developments, rather than lingering effects from the recession. One key factor is labor market polarization—manifested in the gradual disappearance of manual jobs—which helps predict declining worker attachment across states. This has been reinforced by other long-term economic and social trends, such as health considerations, that also have eroded prime-age labor force attachment.

The ability of the Treasury yield curve to predict future recessions has recently received a great deal of public attention. An inversion of the yield curve—when short-term interest rates are higher than long-term rates—has been a reliable predictor of recessions. The difference between ten-year and three-month Treasury rates is the most useful term spread for forecasting recessions—without any adjustment for an estimate of the underlying term premium. However, such correlations in the data do not identify cause and effect, which complicates their interpretation.

A decade after the last financial crisis and recession, the U.S. economy remains significantly smaller than it should be based on its pre-crisis growth trend. One possible reason lies in the large losses in the economy’s productive capacity following the financial crisis. The size of those losses suggests that the level of output is unlikely to revert to its pre-crisis trend level. This represents a lifetime present-value income loss of about $70,000 for every American.

Thanks in large part to recently enacted tax cuts, U.S. fiscal policy has taken a decidedly procyclical turn—providing stimulus when the economy is growing. In fact, the projected increase in the federal deficit over the next few years would represent the most procyclical fiscal policy stance since the Vietnam War. This matters because many recent studies have found that fiscal stimulus has a smaller impact when the economy is strong, implying that the near-term boost to GDP growth could be two-thirds or less of that from previous tax cuts.

Gross domestic income and gross domestic product—GDI and GDP—measure aggregate economic activity using income and expenditure data, respectively. Discrepancies between the initial estimates of quarterly growth rates for these two measures appear to have some predictive power for subsequent GDP revisions. However, this power has weakened considerably since 2011. Similarly, the first revision to GDP growth has less predictive power in forecasting subsequent revisions since 2011. One possible explanation is that evolving data collection and estimation methods have helped improve initial GDP and GDI estimates.

Many investors have turned to emerging market bonds seeking higher returns in the current low interest rate environment. This raises a natural question about the potential for financial instability if investors choose to sell off those bonds quickly. Studying how changes in foreign holdings of Mexican government bonds known as bonos affected their liquidity premiums provides an assessment of the risks and benefits from foreign investment in an emerging economy. Results show that the larger foreign market share of Mexican sovereign bonds tends to increase their liquidity risk premium.

For the economics profession to become more diverse, leaders must focus on building an inclusive culture that welcomes new voices and listens to new ideas. This means putting out the welcome mat, asking newcomers what they think, and letting their answers influence our future. That will be key to changing the statistics. The following is adapted from a speech by the director of research of the Federal Reserve Bank of San Francisco to the Gender and Career Progression Conference at the Bank of England in London on May 14.

Since late 2015, growth in real GDP has consistently exceeded that in real GDI, a prominent alternative measure of aggregate output, with an average difference of about 0.65 percentage point. Is real GDP overstating the expansion? One way to address this question is by comparing the accuracy of these measures in forecasting a benchmark measure of economic activity, the Chicago Fed National Activity Index. The comparison suggests that GDP consistently outperforms GDI in predicting recent real economic activity. Therefore, the weaker GDI growth does not necessarily indicate slower economic growth.

In the current economic environment, it’s important to distinguish between the strong economic conditions and the key longer-run drivers underpinning interest rates. Three factors—demographics, productivity growth, and the demand for safe assets—all point to the natural rate of interest, known as r-star, remaining low for quite some time. The following is adapted from a speech by the president and CEO of the Federal Reserve Bank of San Francisco to the Economic Club of Minnesota in Minneapolis on May 15.

From Bitcoin’s inception in 2009 through mid-2017, its price remained under $4,000. In the second half of 2017, it climbed dramatically to nearly $20,000, but descended rapidly starting in mid-December. The peak price coincided with the introduction of bitcoin futures trading on the Chicago Mercantile Exchange. The rapid run-up and subsequent fall in the price after the introduction of futures does not appear to be a coincidence. Rather, it is consistent with trading behavior that typically accompanies the introduction of futures markets for an asset.

What is the effect of government spending on private consumption? Estimates show that stimulus distributed through the American Recovery and Reinvestment Act had a large positive effect. Estimates from regional data suggest every $100 of stimulus generated an additional $18 within regions. Furthermore, by accounting for economic connections that spread the impact beyond regional borders, a new study finds that every $100 triggered an increase of $40 in overall private consumption in the economy.

The U.S. economy is on course to be as strong as in many decades, and inflation is moving closer to the Federal Reserve’s target. The challenge for monetary policy is to keep it that way. While this is never an easy task, the Fed is well positioned to achieve its goals and respond to unexpected developments. The following is adapted from a speech by the president and CEO of the Federal Reserve Bank of San Francisco to the World Affairs Council of Sonoma in Santa Rosa, CA, on April 6.

The U.S. economy is facing a future of slow growth, mainly because the labor force is expanding less rapidly. However, there are ways to improve. Given the important role education plays in labor force participation, employment, and wages, investing in education across diverse groups offers an important opportunity to raise the speed limit for economic growth. The following is adapted from a speech by the executive vice president and director of research of the Federal Reserve Bank of San Francisco to Lambda Alpha International Land Economics Society in Phoenix, AZ, on March 29.

Some governments sell bonds that protect against variation in inflation. Payments of these bonds are adjusted in response to official inflation measurements with a lag. Considering the effects of such lags could matter both for understanding market-based measures of inflation compensation and for governments deciding what type of inflation-indexed securities to issue. Analyzing pairs of U.K. bonds with almost identical maturities but different lags in inflation adjustment suggests that the lag length matters mainly close to maturity, when seasonality in the underlying price index plays a role.

The term spread—the difference between long-term and short-term interest rates—is a strikingly accurate predictor of future economic activity. Every U.S. recession in the past 60 years was preceded by a negative term spread, that is, an inverted yield curve. Furthermore, a negative term spread was always followed by an economic slowdown and, except for one time, by a recession. While the current environment is somewhat special—with low interest rates and risk premiums—the power of the term spread to predict economic slowdowns appears intact.

Recent research suggests that sustained accommodative monetary policy has the potential to increase financial instability. However, under some circumstances tighter monetary policy may increase financial fragility through two channels. First, a surprise tightening tends to reduce the market value of banks’ equity and raise their market leverage, exacerbating balance sheet fragility in the short run. Second, increases in the federal funds rate have historically been followed by an expansion of assets held by money market funds, which proved to be a source of instability in the 2007-09 financial crisis.

Labor market networks are informal connections among neighbors, coworkers, family, and friends that help people find jobs through sharing information about job openings or applicants. These networks appear to play a valuable role in helping workers recover after mass layoffs. Among relatively low-skilled workers who lost their jobs in mass layoffs, those living in neighborhoods with stronger labor market connections among neighbors found new jobs more quickly. Moreover, workers who found jobs through network connections also found better positions that paid more and lasted longer.

U.S. output has expanded only slowly since the recession trough in 2009, counter to normal expectations of a rapid cyclical recovery. Removing cyclical effects reveals that the deep recession was superimposed on a sharply slowing trend in underlying growth. The slowing trend reflects two factors: slow growth of innovation and declining labor force participation. Both of these powerful adverse forces were in place before the recession and, thus, were not the result of the financial crisis or policy changes since 2009.

The expansion is proceeding at a good pace, unemployment is low, and inflation is finally headed in the right direction. The data show no signs of an economy going into overdrive. This suggests that further gradual increases in interest rates are likely in 2018, assuming the data continue to come in largely as expected. The following is adapted from remarks by the president and CEO of the Federal Reserve Bank of San Francisco to the Financial Women of San Francisco on February 2.

When lenders experience unexpected losses, the supply of credit to borrowers can be disrupted. Researchers and policymakers have long sought estimates of how the availability of loans changes following a shock. The sudden oil price decline in 2014 offers an opportunity to observe precisely how affected lenders altered their portfolios. Banks that were involved with oil and gas producers cut back on some types of lending—consistent with traditional views of bank behavior. However, they expanded other types of lending and asset holdings with a bias towards less risky securities.

Current valuation ratios for U.S. equities and household net worth are high relative to historical benchmarks. The cyclically adjusted price-to-earnings ratio reached its third highest level on record recently, and the ratio of household net worth to disposable income, which includes a broad set of household assets, stands at a record high. Such extreme values of these ratios have historically been followed by reversions toward their long-run averages. However, other current factors, such as low interest rates, caution against bearish forecasts.

2017

The economy is in a good place. Unemployment is low and confidence is high. The challenges to address are good ones: keeping the expansion going, bringing inflation up to its 2% target, and using this period to normalize monetary policy in general and interest rates in particular. The years ahead will require a balanced approach, guided by the data. The following is adapted from remarks by the president and CEO of the Federal Reserve Bank of San Francisco at the 54th Annual Economic Forecast, Phoenix, AZ, on November 29.

After eight years of economic recovery, inflation remains below the FOMC’s target. Dissecting the underlying price data by spending category reveals that low inflation largely reflects prices that are relatively insensitive to overall economic conditions. Notably, modest increases in health-care prices, which have been held down by mandated cuts to the growth of Medicare payments, have helped moderate overall inflation. Further slow growth in health-care prices is likely to remain a drag on inflation.

When the Federal Reserve raises short-term interest rates, the rates on longer-term Treasuries are generally expected to rise. However, even though the Fed has raised short-term interest rates three times since December 2016 and started reducing its asset holdings, Treasury yields have dropped instead. This decoupling of short-term and long-term rates is reminiscent of the “Greenspan conundrum” of 2004–05. This time, however, evidence suggests compelling explanations—a lower “normal” interest rate, the risk of persistently low inflation, and fiscal and geopolitical uncertainty—may account for the yield curve flattening.

History suggests that extreme run-ups in the cyclically adjusted price-earnings ratio are a signal that the stock market may be overvalued. A simple regression model using a small set of macroeconomic explanatory variables can account for most of the run-up in the CAPE ratio since 2009, offering some justification for its current elevated level. The model predicts a modest decline in the ratio over the next decade. All else being equal, such a decline would imply lower stock returns relative to those in recent years when the ratio was rising.

Potential output—the maximum amount an economy can produce over the long run—is an important indicator policymakers use to gauge a country’s current economic health and expectations for future growth. However, potential output can’t be observed directly, and estimating it is difficult, even with modern, sophisticated methods. Monetary policymakers are well advised to account for the perennial problem of uncertainty surrounding these estimates in devising and carrying out policy strategies.

When products disappear from the market with no substitutes from the same manufacturer, they may have been replaced by cheaper or better products from a different manufacturer. Official measurements typically approximate price changes from such creative destruction using price changes for products that were not replaced. This can lead to overstating inflation and, in turn, understating economic growth. A recent estimate suggests that around 0.6 percentage point of growth is missed per year. The bias has not increased over time, however, so it does not explain the slowdown in productivity growth.

Although the labor market has steadily strengthened, wage growth has remained slow in recent years. This raises the question of whether the wage Phillips curve—the traditional relationship between labor market slack and wage growth—has weakened. Estimating a causal link from slack to wage growth using national data is difficult. However, using city-level data over the past 25 years shows that the cross-city relationship has weakened since the Great Recession. Explanations consistent with this timing suggest that the Phillips curve may return to a steeper curve in the future.

The Federal Reserve is moving towards more normal monetary policy, which means rising interest rates. But factors including the real natural rate of interest, a slower sustainable pace of growth, and inflation all point to a new normal where interest rates are lower than in the 1990s and early 2000s. The following is adapted from a speech by the president and CEO of the Federal Reserve Bank of San Francisco to the Community Banking in the 21st Century Research and Policy Conference in St. Louis on October 5.

Exchange rate stabilization or currency “pegs” are among the most prevalent interventions in international financial markets. Removing a peg to a safer currency can make the home currency more risky and less attractive to investors. When a country with market influence removes its peg from a safer country, the risk associated with holding either currency can be affected. Analyzing the effects of a scenario that changes a peg of the renminbi from the U.S. dollar to a basket of currencies suggests that China’s interest rates increase while U.S. interest rates decrease.

Interest rates have been trending down for more than two decades. One possible explanation is the dramatic worldwide demographic transition, with people living longer and population growth rates declining. This demographic transition in the United States—particularly the steady increase in life expectancy—put significant downward pressure on interest rates between 1990 and 2016. Because demographic movements tend to be long-lasting, their ongoing effects could keep interest rates near the lower bound longer. This has the potential to limit the scope for central banks to respond to future recessionary shocks.

More than half a century since the Civil Rights Act became law, U.S. workers continue to experience different levels of success depending on their race. Analysis using microdata on earnings shows that black men and women earn persistently lower wages compared with their white counterparts and that these gaps cannot be fully explained by differences in age, education, job type, or location. Especially troubling is the growing unexplained portion of the divergence in earnings for blacks relative to whites.

During the recession and recovery, hiring has been slower than might be expected considering the large numbers of vacant jobs and unemployed individuals. This raises some concern about structural changes in the process of matching job seekers with employers. However, the standard measures account for only the unemployed and not those who are out of the labor force. Including other non-employed groups in the measured pool of job seekers while adjusting for different job finding rates among these groups shows that the decline in matching efficiency is similar to earlier declines.

Although China’s growth has slowed recently, the country’s demand for oil could be entering a period of faster growth that could result in substantially higher oil prices. Because Americans buy and sell oil and petroleum products in the global market, global demand prospects influence the profitability of U.S. oil producers and the costs paid by U.S. consumers. Analysis based on the global relationship between economic development and oil demand illustrates the prospects for Chinese oil demand growth and the resulting opportunities and challenges for U.S. producers and consumers.

The natural rate of unemployment, or u-star, is used by economists and policymakers to help assess the overall state of the labor market. However, the natural rate is not directly observable and must be estimated. A new statistical approach estimates the natural rate over the past 100 years. Results suggest the natural rate has been remarkably stable over history, hovering between 4.5 and 5.5% for long periods, even during the Great Depression. Recent readings on the unemployment rate have been running slightly below the natural rate estimate.

As the economy has transitioned from recovery to expansion, the role of monetary policy has shifted to sustaining the expansion by gradually moving conventional and unconventional policy back to normal. But monetary policy is reaching its limit for stimulating growth, calling for private and public sector investments and policies to step up and take the lead. The following is adapted from a presentation by the president and CEO of the Federal Reserve Bank of San Francisco to the Economic Club of Las Vegas in Las Vegas on August 2.

Interest rates are inherently difficult to predict, and the simple random walk benchmark has proven hard to beat. But macroeconomics can help, because the long-run trend in interest rates is driven by the trend in inflation and the equilibrium real interest rate. When forecasting rates several years into the future, substantial gains are possible by predicting that the gap between current interest rates and this long-run trend will close with increasing forecast horizon. This evidence suggests that accounting for macroeconomic trends is important for understanding, modeling, and forecasting interest rates.

The pace of business start-ups in the United States has declined over the past few decades. Economic theory suggests that business creation depends on the available workforce, and data analysis supports this strong link. By contrast, the relationship between start-ups and labor productivity is less well-defined, in part because entrepreneurs face initial costs that rise with productivity, specifically their own lost income from alternative employment. Overall, policies that incorporate improving labor availability may help to boost new business growth.

Demographic factors like slowing population and labor force growth, along with a global productivity slowdown, are fundamentally redefining achievable economic growth. These global shifts suggest the disappointing growth in recent years is a harbinger of the future. While the causes of the growth slump are well defined, the consequences will be shaped by choices that policymakers are grappling with around the globe. The following is adapted from a presentation by the president and CEO of the Federal Reserve Bank of San Francisco at Macquarie University, Sydney, Australia, on June 27.

Interest rates in the United States have diverged from the rates of other countries over the past few years. Some commentators have voiced concerns that, as a result, exchange rates might be more sensitive to unanticipated changes in U.S. interest rates now than they were historically. However, an examination of market-based measures of policy expectations finds no convincing evidence that the U.S. dollar has become more sensitive since 2014.

Interest rates during the current economic recovery have been unusually low. Some have argued that yields have been pushed down by declines in longer-run expectations of the normal inflation-adjusted short-term interest rate—that is, by a drop in the so-called equilibrium or natural rate of interest. New evidence from financial markets shows that a decline in this rate has indeed contributed about 2 percentage points to the general downward trend in yields over the past two decades.

Investors’ demand for safe assets tends to increase when there’s more uncertainty, as in recessions. Consistent with this idea, short-term movements in the natural rate of interest, or r-star, are negatively correlated with an index of macroeconomic uncertainty. This relationship may be relevant for assessing monetary policy. An estimated policy rule that incorporates both r-star and the uncertainty index can largely reproduce the path of the federal funds rate since 1988, except during periods when policy was constrained by the zero lower bound.

China’s central bank frequently adjusts its reserve requirements for commercial banks as a way to stabilize economic fluctuations. These adjustments affect the overall credit supply but can also lead to the reallocation of credit and capital. Evidence shows that increases in reserve requirements raise off-balance-sheet lending, which typically benefits China’s more productive private sector, at the expense of on-balance-sheet loans to less productive state-owned enterprises. Under certain conditions, reserve requirements can be a useful additional policy instrument for improving resource allocations and also for macroeconomic stabilization in China.

Consumer attitudes about buying and selling homes can inform us about future housing and mortgage markets. The Home Purchase Sentiment Index (HPSI) summarizes data from the National Housing Survey on consumers’ conditions, attitudes, and intentions about housing. The HPSI shows promise both as a stand-alone indicator and as a supplement for evaluating and forecasting housing and mortgage markets. Analysis reveals the index accurately projected strong home sales in 2014 and 2015 and a weaker outlook toward the end of 2016, following the sharp rise in mortgage interest rates.

Now is the right time to ask whether the monetary policy framework and strategy that worked well in the past are well suited to address the challenges ahead. A flexible price-level targeting framework has the important traits of adaptability, accessibility, and accountability. It also offers significant advantages over inflation targeting for meeting price stability and employment goals. The following is adapted from a presentation by the president and CEO of the San Francisco Fed to the Shadow Open Market Committee in New York on May 5.

Insurance companies write policies to cover potential risks far into the future. Because the life of these contracts can extend well beyond the 30-year maturities for the longest U.S. Treasuries, it’s difficult to measure the interest rate risk involved. A new study describes how the long-term interest rates required to evaluate such long-lived liabilities can be extrapolated from shorter-maturity bond yields using a standard yield curve model. These extrapolations are a useful tool since they have very small errors relative to the yield curve variation typically considered for risk management.

People of the United Kingdom voted to exit the European Union last June, a process dubbed “Brexit.” The persistent depreciation of the British pound since the vote suggests that U.K. economic conditions will be weakened over the long run following the separation from the EU. This projection of a persistent economic loss is based on the expected reversal of earlier gains from trade with other EU members and reduced cross-border labor flows.

Newspaper articles and editorials about the economy do more than just report on official data releases. They also often convey how the journalist and those interviewed feel about the economy. Researchers have recently developed ways to extract data on sentiment from news articles using text analysis and machine learning techniques. These measures of news sentiment track current economic conditions quite well. In fact, they often do a better job than standard consumer sentiment surveys at forecasting future economic conditions.

If inflation increases rapidly, how do we know that higher interest rates will bring prices under control? And how do we know how much of the monetary “medicine” to administer? Economics relies primarily on observational data to answer such questions, while medical research uses randomized controlled trials to evaluate treatments. Applying that method to economics, the long history of international finance turns out to be an excellent laboratory to conduct monetary experiments. These experiments suggest that interest rates have sizable effects on the economy.

The elevated number of non-employed people who are out of the labor force has raised some concerns about how well the headline unemployment rate measures available labor. An alternative measure of labor utilization, the Non-Employment Index, accounts for all non-employed individuals, distinguishing between groups like short-term versus long-term unemployed, discouraged workers, retirees, and disabled individuals, and adjusting for how likely each is to transition to employment. Current data show the index is very close to its value in 2005–06, the period near the peak of the previous economic expansion.

The U.S. unemployment rate fell to a very low level at the end of 2016, raising the question of whether the labor market has become too tight. After applying a new method to adjust for demographic changes in the labor force, the current unemployment rate is still 0.3 to 0.4 percentage point higher than at past labor market peaks. This indicates that the labor market may not be quite as tight as the headline unemployment rate suggests.

Population aging and the consequent increased financial burden on the U.S. Social Security system is driving new proposals for program reform. One major reform goal is to create stronger incentives for older individuals to stay in the workforce longer. However, hiring discrimination against older workers creates demand-side barriers that limit the effectiveness of these supply-side reforms. Evidence from a field experiment designed to test for hiring discrimination indicates that age discrimination makes it harder for older individuals, especially women, to get hired into new jobs.

The decline in the natural rate of interest, or r-star, over the past decade raises three important questions. First, is this low level for the real short-term interest rate unique to the U.S. economy? Second, is the natural rate likely to remain low in the future? And third, is this low level confined to “safe” assets? In answer to these questions, evidence suggests that low r-star is a global phenomenon, is likely to be very persistent, and is not confined only to safe assets.

Slowing growth in U.S. productivity after 2004 is sometimes blamed on measurement problems, particularly in assessing the gains from innovation in IT-related goods and services. However, mismeasurement also occurred before the slowdown and, on balance, there is no evidence that it has worsened. Some innovations—such as free Internet services—have grown increasingly important, but they mainly affect leisure time. Moreover, the non-market benefits do not appear large enough to offset the effects of the business-sector slowdown.

In the Treasury market, the most recently issued security typically trades at a higher price than more seasoned but otherwise comparable securities. The difference is known as the “on-the-run” premium. This phenomenon opens the question of whether a similar premium exists for all Treasury bonds. Examining yield spreads between pairs of inflation-protected securities, known as TIPS, that have identical maturities but different issue dates suggests that this is not the case: There is no on-the-run premium in the TIPS market at this time.

The U.S. economy is in good shape, with the labor market at maximum employment and inflation nearing the Fed’s goal. Given the progress made on these goals and signs of continued solid momentum, it makes sense to gradually move interest rates toward more normal levels. The actual pace of increases will be driven by the evolution of economic conditions and its implications for achieving the Fed’s dual mandate objectives. The following is adapted from a speech by the president and CEO of the Federal Reserve Bank of San Francisco to the 2017 Economic Forecast in Sacramento on January 17.

The rate of business turnover has declined since the late 1970s, which some argue has hampered growth in innovation and productivity. This sounds like a plausible contributor to lackluster economic growth, but the connection between business turnover and productivity is more subtle. First, while business turnover has steadily declined over the past 35 years, aggregate productivity growth has not. Second, even when business starts were at historical highs, existing firms lost very little market share to new firms. This suggests that older firms are just as innovative as newcomers.

2016

To foster transparency and accountability in monetary policy, the Federal Open Market Committee publishes a statement immediately following every FOMC meeting, followed by the full minutes of the meeting three weeks later. Evidence suggests the release of the minutes can have a sizable impact on Treasury bond yields. The impacts are largest when the tone of the minutes differs from the tone of the statement. This presumably leads markets to change their expectations of future monetary policy.

Despite recent increases, long-term interest rates remain close to their historical lows. A variety of structural factors, notably slower productivity growth and a surplus of global saving, likely have lowered expectations of steady-state interest rates and pushed down long-term yields through the expectations component. In addition, accommodative monetary policy in the United States and abroad appears to have lowered the term premium on long-term bonds.

The prices of special securities known as TIPS can give some insight into how investors view the outlook for future inflation. New research uses a novel term structure model of nominal and real yields to estimate how much the liquidity premium embedded in the prices of these securities have varied over time. Accounting for variation in the premiums notably increases estimates of the inflation expectations underlying market-based measures of inflation compensation, particularly during the most recent financial crisis.

Job mobility in the United States has been slowing for almost two decades. The most prominent measure of mobility is direct transitions from one job to another. This measure has declined substantially among young workers ages 16 to 24 since the late 1990s, which helps explain the majority of the overall decline in job-to-job transition rates. However, for workers ages 25 and older, the labor market is essentially as dynamic today as it was 20 years ago.

At the end of 2015, many forecasters, including some Fed policymakers, projected four hikes in the federal funds rate in 2016. Instead, there have been no increases so far this year. While this shift in Fed policy has puzzled some observers, such a course correction is not unusual from a historical perspective. In addition, given recent changes in economic conditions, the reduced federal funds rate path this year is completely consistent with past Fed behavior.

With the U.S. labor market at or near maximum employment, assessing trend job growth has become increasingly important. This “breakeven” rate, which is the pace of job growth needed to maintain a healthy labor market, depends primarily on growth in the labor force. Estimates that account for population aging and potential labor force participation trends suggest that trend growth ranges between about 50,000 and 110,000 jobs per month. Actual job growth has been well above this pace, implying that it can slow substantially in the future without undermining labor market health.

The increase in U.S. income inequality since 1970 largely reflects gains made by households in the top 20% of the income distribution. Estimates suggest that households outside this group have suffered significant losses from foregone consumption, measured relative to a scenario that holds inequality constant. A substantial mitigating factor for the losses has been the dramatic rise in government redistributive transfers, which have doubled as a share of U.S. output over the same period.

Estimates suggest the new normal for U.S. GDP growth has dropped to between 1½ and 1¾%, noticeably slower than the typical postwar pace. The slowdown stems mainly from demographics and educational attainment. As baby boomers retire, employment growth shrinks. And educational attainment of the workforce has plateaued, reducing its contribution to productivity growth through labor quality. The GDP growth forecast assumes that, apart from these effects, the modest productivity growth is relatively “normal”—in line with its pace for most of the period since 1973.

Understanding how rain, snow, and cold weather affect the economy is important for interpreting economic data. A new study uses county-level data to measure the effect of unseasonable weather on monthly U.S. employment. The resulting estimates quantify how the atypical weather this year explains some of the unexpected fluctuations in hiring at the national level.

During the recovery from the Great Recession, real interest rates on government securities have stayed low, but real returns on capital have rebounded. Although this divergence is puzzling in light of standard economic theory, it can be explained by credit market imperfections that raise the cost of capital and depress aggregate investment. The unusually slow credit market recovery is likely to have contributed to the diverging paths of the risk-free rate and returns on capital. It may have also contributed to a slow recovery in investment and output.

The collapse of an asset price bubble usually creates a great deal of economic disruption. But bubbles are hard to anticipate and costly to deflate. As a result, policymakers struggle to determine how they should respond, if at all. Evaluating the economic costs of past equity and real estate bubbles—with particular attention to how much credit grew during boom phases—can provide valuable insights for this debate. A recent study finds that equity bubbles are relatively benign. More danger comes from housing bubbles in which credit grows rapidly.

In response to the global financial crisis, the Federal Reserve relied more heavily on communication to shape expectations. Since 2012 the Fed has released the Summary of Economic Projections reflecting the range of expectations from FOMC meeting participants. Policymakers also deliver speeches to further clarify their views. Using textual analysis to quantify the content of those speeches reveals a somewhat diverse set of views among policymakers. Regardless of the broad range of views, there is a positive relationship between the content of the centermost speech and the median projection for the policy rate.

The “natural” rate of interest—the real rate consistent with full use of economic resources and steady inflation near the Fed’s target level—is an important benchmark for monetary policy. Current estimates suggest that this rate is near zero, but it is expected to rise gradually in the years ahead as real GDP returns to its long-run potential. If the historical statistical relationship between the growth rate of potential GDP and the natural rate holds true in the future, then a 2% long-run growth rate would imply a long-run natural rate of around 1%.

Despite the very real struggles that some parts of the country, including Alaska, are facing, the broader national economy is in good shape: We’re at full employment, and inflation is well within sight of, and on track to reach, our target. Under these conditions, it makes sense for the Fed to gradually move interest rates toward more normal levels. The following is adapted from a presentation by the president and CEO of the Federal Reserve Bank of San Francisco to the Anchorage Economic Development Corporation in Anchorage, Alaska, on August 18.

Central banks and governments around the world must be able to adapt policy to changing economic circumstances. The time has come to critically reassess prevailing policy frameworks and consider adjustments to handle new challenges, specifically those related to a low natural real rate of interest. While price level or nominal GDP targeting by monetary authorities are options, fiscal and other policies must also take on some of the burden to help sustain economic growth and stability.

Following reports in 2015 that the Federal Reserve would likely begin to raise the short-term policy interest rate—after seven years of near-zero levels—net capital outflows from emerging economies intensified. Many of these countries also experienced large currency depreciations. These developments were similar to those following reports in 2013 about the possible tapering of the Fed’s asset purchases. Furthermore, in both episodes, financial market reactions varied across these developing economies according to each country’s own economic situation.

After the onset of the global financial crisis, the Federal Reserve had to rely on other tools—including communication—to work around the constraints of being unable to lower the federal funds rate below zero. One way to assess how effective these communications were is by estimating how interest rates on bonds with different maturities reacted to Fed communications before and after the zero-bound period. A measure based on news reports of Fed communications suggests that this tool gave the Fed some ability to affect long-term yields through its communications.

Some recent research has suggested that macroeconomic variables, such as output and inflation, can improve interest rate forecasts. However, the evidence for this puzzling result is based on unreliable statistical tests. A new simple method more reliably assesses which variables are useful for forecasting. The results from this method suggest that some of the published evidence on the predictive power of macroeconomic variables may be spurious, supporting the more traditional view that current interest rates contain all the relevant information for predicting future interest rates.

Some closely watched measures of inflation expectations have been in gradual decline over the past five years. Over the same time, oil prices have fallen dramatically. Although the movements in energy prices are normally considered temporary, they appear to have played a large role in pushing down some longer-term forecasts for consumer price index inflation from professional forecasters. Analysis shows the drop in energy prices can explain about three-fourths of the decline in these professional inflation forecasts over the past five years.

China has recently considered reforming its regulation of initial public offerings in equity markets. Current policy allows more IPOs in rising markets but restricts new issues in falling markets, possibly to avoid pushing down values of existing stocks. However, recent research finds China’s IPO activity has no effect on stock price changes, perhaps because of the low volume relative to the overall market. As such, cyclical restrictions on IPOs do not appear to have stabilized Chinese markets, so policy reforms may improve market efficiency without increasing volatility.

The muted housing recovery in recent years can be traced in part to slower household formation among young adults. Analysis suggests that the boom and bust in housing has been a key factor. Recent weakness in household formation relative to population growth among young adults represents a reversal of the unusual strength during the boom years. The net effect has left shares of current young adults heading households at levels similar to those in the mid-1990s before the housing boom.

The labor market looks good, inflation is moving back toward the FOMC’s target, and the economic expansion remains on track. Under these conditions, monetary policy is going back to the basics. Sparking faster growth in the future through innovation and more rapid productivity gains will require investments to build human capital, which is outside the realm of monetary policy. The following is adapted from a presentation by the president and CEO of the Federal Reserve Bank of San Francisco to the Sacramento Economic Forum in Sacramento, California, on May 13.

A steady downward trend in health-care services price inflation over the past decade has been a major factor holding down core inflation. Much of this downward trend reflects lower payments from public insurance programs. Looking ahead, current legislative guidelines imply considerable restraint on future public insurance payment growth. Therefore, overall health-care services price inflation is unlikely to rebound and appears likely to continue to be a drag on inflation.

How well stress tests measure a bank’s ability to survive adverse conditions depends on the statistical modeling approach used. Banks can access data on loan characteristics to precisely estimate individual default risk. However, macroeconomic scenarios used for stress tests—as well as the reports banks must provide—are for a bank’s entire portfolio. So, is it better to aggregate the data before or after applying the model? Research suggests a middle-of-the-road approach that applies models to data aggregated at an intermediate level can produce accurate and stable results.

The plunge in oil prices since the middle of 2014 has not translated into a dramatic boost for consumer spending, which has continued to grow moderately. This has been particularly surprising since the sharp drop should free up income for households to use toward other purchases. Lessons from an empirical model of learning suggest that the weak response may reflect that consumers initially viewed cheaper oil as a temporary condition. If oil prices remain low, consumer perceptions could change, which would boost spending.

Market participants typically update their views on future policy actions based on incoming economic data. However, when interest rates are near zero, monetary policy actions are viewed as less data dependent than in “normal” times. From 2010 to 2014, market expectations of interest rates over the near term exhibited little data dependence. In the past year or so, market-based measures of data dependence have risen considerably, although they are still below earlier norms. This suggests that investors are increasingly viewing monetary policy actions as data dependent.

Persistently low price inflation, falling energy prices, and a strengthening dollar have helped push down market-based measures of long-term inflation compensation over the past two years. The decline in inflation compensation could reflect a lower appetite for risk among investors or decreased market liquidity. A third alternative supported by recent research suggests that the decline reflects lower long-term inflation expectations among investors. Projections indicate the underlying expectations will revert back to typical long-run levels only slowly.

Domestic bond markets allow governments to inflate away their debt obligations. However, they also may create a group of bond holders with the influence and desire to demand lower stable inflation. These competing interests suggest the net impact of creating a local currency bond market on inflation is ambiguous. Recent research finds that the creation of such markets in countries with an inflation target does reduce inflation: Countries with bond markets experience inflation approximately 3 percentage points lower than those without.

The economic benefits of sharing a currency like the euro continue to be debated. In theory, countries that use the same currency face lower trade costs and exchange rate risk and are able to compare prices across borders more easily. These advantages should help increase trade among the economies involved. New estimates suggest that this has been the case in Europe, though perhaps to a lesser degree than previously thought.

Investors have a hard time accounting for uncertainty when calculating how much risk they are willing to bear. They can use economic models to project future earnings, but many models are misspecified along important dimensions. One method investors appear to use to protect against particularly damaging errors in their model is by projecting worst-case scenarios. The responses to such pessimistic predictions provide insights that can explain many of the puzzles about asset prices.

While most labor market indicators point to an economy near full employment, a notable exception is the sluggish rise of wages. However, this slow wage growth likely reflects recent cyclical and secular shifts in the composition rather than a weak labor market. In particular, while higher-wage baby boomers have been retiring, lower-wage workers sidelined during the recession have been taking new full-time jobs. Together these two changes have held down measures of wage growth.

The Federal Reserve uses a number of approaches to inform its policy decisions—they’re all insightful, they’re all useful, and they’re all a part of the debate. But none is absolutely fail-safe. The idea that policymakers should follow only one approach without deviation is ill-advised. An abundance of perspectives is fundamental to the Fed’s success. The following is adapted from a presentation by the president and CEO of the Federal Reserve Bank of San Francisco to New York University Stern School of Business in New York on February 25.

Headline news can give false impressions of what motivates monetary policymakers. While international developments and financial market volatility are closely monitored, what matters for policy is how those things affect jobs and inflation. The U.S. economy has had strong job growth, and inflation is low but on course to reach target. The best course remains a gradual pace of policy rate increases. The following is adapted from a presentation by the president and CEO of the Federal Reserve Bank of San Francisco to Town Hall Los Angeles on February 18.

In the wake of the financial crisis, the Federal Reserve dropped the federal funds rate to near zero to bolster the U.S. economy. Recent research suggests that the constraint preventing this rate from being even lower has kept the economy from reaching its full potential. Given the lingering economic slack, allowing inflation to rise temporarily above the Fed’s 2% target might help achieve a better balance between the Fed’s dual mandates of maximum employment and stable prices more quickly.

Is the current recovery more likely to end because it’s lasted so long? Have various imbalances and rigidities accumulated to make the economy frailer and more susceptible to a recessionary shock? Recent history suggests the answer is no. Instead, a long recovery appears no more likely to end than a short one. Like Peter Pan, recoveries appear to never grow old.

The percentage of people active in the labor force has dropped substantially over the past 15 years. Part of this decline appears to be the result of secular factors like the aging of the workforce. However, the participation rate among people in their prime working years—ages 25 to 54—has also fallen. Recent research suggests this decline among prime-age workers can be attributed in large part to lower participation from among the higher-income half of U.S. households.

The Federal Reserve has started the process of raising interest rates, in line with ongoing improvement in U.S. economic conditions. The path for subsequent interest rate increases, however, is likely to be shallow compared with past tightening cycles. This reflects in part growing evidence that the new normal for interest rates is lower than in the past. The following is adapted from a presentation by the president and CEO of the Federal Reserve Bank of San Francisco to the California Bankers Association in Santa Barbara, California, on January 8.

2015

Setting a higher minimum wage seems like a natural way to help lift families out of poverty. However, minimum wages target individual workers with low wages, rather than families with low incomes. As a result, a large share of the higher income from minimum wages flows to higher-income families. Other policies that directly address low family income, such as the earned income tax credit, are more effective at reducing poverty.

The minimum wage has gained momentum among policymakers as a way to alleviate rising wage and income inequality. Much of the debate over this policy centers on whether raising the minimum wage causes job loss, as well as the potential magnitude of those losses. Recent research shows conflicting evidence on both sides of the issue. In general, the evidence suggests that it is appropriate to weigh the cost of potential job losses from a higher minimum wage against the benefits of wage increases for other workers.

The U.S. economy is on the cusp of full health, supported by highly accommodative monetary policy in recent years. The labor market is nearing maximum employment. Inflation remains too low, but measures of its underlying trend suggest that it is not far from the Fed’s 2% target. With real progress toward these goals, the conversation has turned to normalizing policy. The following is adapted from a presentation by the president and CEO of the Federal Reserve Bank of San Francisco to community leaders in Portland, OR, on December 2.

China’s demand for imports helps support the global economic recovery, so China’s recent economic slowdown has caused international concern. China’s slowdown is concentrated in the industrial sector, while its emerging service sector has shown much new strength. However, China’s service sector is relatively closed and relies only modestly on imports. Accordingly, service sector growth is unlikely to offset the adverse implications of a slowing China for global trade.

After peaking in 2006, the median U.S. house price fell about 30%, finally hitting bottom in late 2011. Since then, house prices have rebounded strongly and are nearly back to the pre-recession peak. However, conditions in the latest boom appear far less precarious than those in the previous episode. The current run-up exhibits a less-pronounced increase in the house price-to-rent ratio and an outright decline in the household mortgage debt-to-income ratio—a pattern that is not suggestive of a credit-fueled bubble.

Labor costs constitute a substantial share of business expenses, and it is natural to expect wages to be an important determinant of prices. However, research suggests that wages do not contain much useful information for forecasting price inflation that is not available from other indicators. Therefore, one should not infer too much from recent wage data regarding the future path of inflation.

Short-term interest rates in the United States have been very low since the financial crisis. Projections of the natural rate of interest indicate that a gradual return of short-term interest rates to normal over the next five years is consistent with promoting maximum employment and stable inflation. Uncertainty about the natural rate that is most consistent with an economy at its full potential suggests that the pace of normalization may be even more gradual than implied by these projections.

The recent Federal Open Market Committee decision to hold off on raising interest rates reflected conflicting signals, with favorable U.S. economic conditions offset by downside risks from abroad. However, the economy continues to make progress toward achieving the FOMC’s goals. If developments stay on track, the process of monetary policy normalization is likely to start later this year. The following is adapted from a presentation by the president and CEO of the Federal Reserve Bank of San Francisco to the UCLA Anderson School of Management in Los Angeles on September 28, 2015.

A substantial decline in market-based measures of inflation expectations has raised concerns about low future inflation. An important question to address is whether these measures contain information that can improve upon alternative forecasting methods. This analysis finds that market-based inflation forecasts generally are no more accurate than surveys of professional forecasters or simple forecast rules. This suggests that financial markets can provide little additional useful forward-looking information about inflation.

A new proposal by the Basel Committee on Banking Supervision for setting the amount of capital banks must hold against potential losses from interest rate risk uses only a few, very stylized scenarios. Analysis shows the proposed scenarios are extremely unlikely to occur. While they may be appropriate for setting bank capital guidelines, they are much less relevant for everyday risk management. Instead, using a modeling framework with a plausible range of interest rate scenarios would be more relevant to help banks manage their interest rate risk.

Central banks debate whether using monetary policy to foster financial stability through house prices is advisable. Although a rise in interest rates tends to lower house prices, it may come at a significant cost through reduced economic output and inflation. This implies a very costly tradeoff when macroeconomic and financial stability goals are in conflict. The following is adapted from a presentation by the president and CEO of the Federal Reserve Bank of San Francisco to the Bank Indonesia–BIS Conference in Jakarta on August 20.

Much recent discussion has suggested that the official real GDP data are inadequately adjusted for recurring seasonal fluctuations. A similar pattern of insufficient seasonal adjustment also affects the published data for a key measure of price inflation. Still, such residual seasonality in the published output and inflation statistics is unlikely to mislead Federal Reserve policymakers or adversely affect the setting of monetary policy.

The recent slowdown in China’s growth has caused concern about its long-term growth prospects. Evidence suggests that, before 2008, China’s growth miracle was driven primarily by productivity improvement following economic policy reforms. Since 2008, however, growth has become more dependent on investment and overall growth has slowed. If the recent reform plans can successfully address the country’s structural imbalances, China could maintain a solid growth rate that might help smooth its transition to high-income status.

Policymakers disagree over whether central banks should use interest rates to curb leverage and asset price booms. Higher interest rates make mortgages more expensive and could prevent borrowers from bidding up house prices to create a boom. However, rough calculations show that the size of rate increase needed to do so might also boost unemployment and push down inflation. Thus, using this type of policy tool may cause the central bank to deviate significantly from its goals of full employment and price stability.

Inflation has remained below the FOMC’s long-run target of 2% for more than three years. But this sustained undershooting does not yet signal a statistically significant departure from the target once the volatility of the 12-month mean inflation rate is taken into account. Furthermore, the empirical Phillips curve relationship that links inflation to the size of production or employment gaps has been roughly stable since the early 1990s. Hence, continued improvements in production and employment relative to their long-run trends would be expected to put upward pressure on inflation.

The U.S. economy is looking quite good. Growth is on a solid trajectory, and the FOMC’s maximum employment goal is in sight. Risks from abroad are unlikely to overturn strong U.S. fundamentals. Still, the exact timing of an initial interest rate increase will depend on convincing evidence that inflation is heading back toward target. The following is adapted from a presentation by the president and CEO of the Federal Reserve Bank of San Francisco to the International Conference of Commercial Bank Economists in Los Angeles on July 8.

Over the past several years, the Federal Open Market Committee’s longer-run forecasts of the short-term interest rate and unemployment rate have steadily declined. These forecasts reflect the Committee’s views about the levels of the policy interest rate and unemployment rate that will eventually prevail when the economy returns to normal. A simple monetary policy rule illustrates how the reductions in these forecasts can imply a lower projected path for the policy rate.

Policymakers often consider temporarily redistributing income from rich to poor households to stimulate the economy. This is based in part on the idea that poor households spend a larger share of their income than rich ones do. However, ample evidence suggests that the difference in spending between these groups is significantly smaller than commonly assumed. A second assumption is that redistribution through policy is more efficient than through capital markets. Whether this is true is important to consider when proposing this type of stimulus policy.

The Swiss National Bank expanded bank reserves as part of its unconventional monetary policy during the European sovereign debt crisis. The unprecedented expansion involved short-term rather than long-term asset purchases. This approach provides novel insights into how central bank balance sheet expansions affect interest rates. In particular, it illustrates how an expansion of reserves can lower long-term yields through a reserve-induced portfolio balance effect that is independent of the assets purchased.

The incidence of involuntary part-time work surged during the Great Recession and has stayed unusually high during the recovery. This may reflect more labor market slack than is captured by the unemployment rate alone. Analysis across states and over time indicates that a substantial part of the increase is related to the business cycle. However, structural factors such as changes in industry composition, population demographics, and labor costs have also contributed. This suggests that involuntary part-time work may remain significantly above its pre-recession level as the labor market continues to recover.

Events of the past decade have refocused attention on the potential contributions of monetary policy and macroprudential approaches to fostering financial stability. However, monetary policy is poorly suited for dealing with financial stability concerns. Instead, given the scarcity of explicit macroprudential tools in the United States, microprudential regulations and supervision are used to achieve macroprudential goals. The following is adapted from a presentation by the president and CEO of the Federal Reserve Bank of San Francisco to the Symposium on Asian Banking and Finance in Singapore May 28.

The U.S. economy is on solid footing. The labor market is nearing full employment, and inflation should move back toward the Federal Open Market Committee’s target. A likely gradual removal of highly accommodative monetary policy could begin at any upcoming FOMC meeting. However, the exact timing will be driven by the incoming data. The following is adapted from a presentation by the president and CEO of the Federal Reserve Bank of San Francisco to the New York Association for Business Economics in New York on May 12.

The official estimate of real GDP growth for the first three months of 2015 was shockingly weak. However, such estimates in the past appear to have understated first-quarter growth fairly consistently, even though they are adjusted to try to account for seasonal patterns. Applying a second round of seasonal adjustment corrects this residual seasonality. After this correction, aggregate output grew much faster in the first quarter than reported.

The dilemma of central bank independence has been around a long time. Past attempts to solve it through an operational mandate such as the gold standard have proven ineffective. The alternative approach of achieving economic goals through reliance on a fixed policy rule also poses practical challenges. A more promising path is to enhance accountability and transparency within an existing goal mandate framework. The following is adapted from a presentation by the president and CEO of the Federal Reserve Bank of San Francisco to Chapman University in Orange, California, on May 1.

Inflation targeting is often considered the most appropriate monetary policy framework for central banks seeking price stability. While a target can help stabilize inflation, the implications for a country’s growth are less clear. Advanced economies experienced higher economic growth immediately following the transition to inflation targeting. However, developing economies experienced only modest gains that were close to their trend growth. One explanation is that transitioning to a low-inflation regime can be more costly for less stable countries that have higher inflation expectations and less credible policies.

The 2006 health-care reform in Massachusetts relied heavily on the private insurance market. Recent evidence shows that the reform boosted payments to physicians from private insurers by 13% relative to other areas. This increase began immediately before the reform became law, suggesting that insurers raised payments in anticipation of the change. The reform may have also caused the state’s insurance premiums to fall. Overall, evidence suggests that the Massachusetts health-care reform shifted dollars away from insurers and towards providers and consumers.

Financial market prices contain valuable information about investors’ views regarding future interest rates, inflation, and other economic variables. However, such market-based expectations can be hard to interpret because changes in risk and liquidity premiums also affect asset prices. In practice, policymakers should be cautious in relying on the expectations information in market prices.

Based on surveys of professional forecasters, expectations for price inflation 5 to 10 years ahead have edged down over the past few years. This decline seems to be primarily driven by revised expectations from forecasters who overestimated inflation in the aftermath of the Great Recession. Currently, the median survey-based expectation for long-term inflation is close to its pre-recession level and appears well anchored at the Fed’s 2% longer-run inflation objective.

Every month, millions of workers search for new jobs although they already have one. About one-tenth of these searchers switch employers in the following month. However, most of the job switchers in the United States never reported having looked for a job. This implies that, rather than those workers finding jobs, the jobs actually found them.

In the six decades following World War II, bank lending measured as a ratio to GDP has quadrupled in advanced economies. To a great extent, this unprecedented expansion of credit was driven by a dramatic growth in mortgage loans. Lending backed by real estate has allowed households to leverage up and has changed the traditional business of banking in fundamental ways. This “Great Mortgaging” has had a profound influence on the dynamics of business cycles.

The U.S. economy is likely to reach the Federal Reserve’s maximum employment goal later this year. Although inflation has remained persistently low, it is expected to return to the Fed’s 2% target over the next few years. Due to the lags between monetary policy’s implementation and its effects, the time is coming to take the first step toward normalizing monetary policy by raising short-term interest rates. The following is adapted from a presentation by the president and CEO of the Federal Reserve Bank of San Francisco to the CFA Society Hawaii on March 5, 2015.

Place-based policies such as enterprise zones offer economic incentives to firms to create jobs in economically challenged areas. Evidence on the effectiveness of enterprise zones is mixed. There is no clear indication that they successfully create jobs. However, positive effects are evident for other policies, including discretionary subsidies that target specific firms, infrastructure spending that targets specific areas, and investment in higher education and university research.

State and local governments frequently offer tax incentives to attract businesses to locate in their area. Proponents view these incentives as a valuable tool to encourage economic development. Critics, on the other hand, argue either that incentives have little effect on business location decisions—and hence are wasteful giveaways—or that their benefits come at the expense of reduced economic activity in other areas. A key element in this debate is distinguishing what is best from a local versus a national perspective.

Animal spirits are often suggested as a cause of business cycles, but they are very difficult to define. Recent research proposes a novel explanation based on the changing level of risk over time and people’s uncertainty about how the world works. The interaction of these two can lead to significant business cycle fluctuations in response to spikes in volatility. This finding gives researchers an alternative to irrational behavior as an explanation for why swings in consumer sentiment appear to drive the business cycle.

Information technology fueled a surge in U.S. productivity growth in the late 1990s and early 2000s. However, this rapid pace proved to be temporary, as productivity growth slowed before the Great Recession. Furthermore, looking through the effects of the economic downturn on productivity, the reduced pace of productivity gains has continued and suggests that average future output growth will likely be relatively slow.

Since 2007, Federal Open Market Committee participants have been persistently too optimistic about future U.S. economic growth. Real GDP growth forecasts have typically started high, but then are revised down over time as the incoming data continue to disappoint. Possible explanations for this pattern include missed warning signals about the buildup of imbalances before the crisis, overestimation of the efficacy of monetary policy following a balance-sheet recession, and the natural tendency of forecasters to extrapolate from recent data.

The earnings gap between people with a college degree and those with no education beyond high school has been growing since the late 1970s. Since 2000, however, the gap has grown more for those who have earned a post-graduate degree as well. The divergence between workers with college degrees and those with graduate degrees may be one manifestation of rising labor market polarization, which benefits those earning the highest and the lowest wages relatively more than those in the middle of the wage distribution.

Despite considerable improvement in the labor market, growth in wages continues to be disappointing. One reason is that many firms were unable to reduce wages during the recession, and they must now work off a stockpile of pent-up wage cuts. This pattern is evident nationwide and explains the variation in wage growth across industries. Industries that were least able to cut wages during the downturn and therefore accrued the most pent-up cuts have experienced relatively slower wage growth during the recovery.

2014

The retirement of the baby boomers is expected to severely cut U.S. stock values in the near future. Since population aging is widespread across the world’s largest countries, this raises the question of whether global aging could adversely affect the U.S. equity market even further. However, the strong relationship between demographics and equity values in this country do not hold true in other industrial countries. This suggests that global aging is unlikely to create additional headwinds for U.S. equities.

Financial incentives from state governments are part of a growing trend of policies designed to spur innovation clusters in specific regions. Biotechnology industry clusters in particular have benefited from these subsidies, which have boosted the number of star biotech scientists in those states by roughly 15%. Likewise, the number of biotech jobs overall has grown in states that offered incentives, although they have had little impact on salaries. Incentives have also spilled over to generate sizable effects in local service sectors.

Since the Great Recession, standard ways of measuring the labor market have given mixed signals about the strength of the U.S. recovery. This has increased the uncertainty around how to interpret job market conditions, which has made calibrating monetary policy to achieve full employment more challenging. Ultimately, policymakers need to make judgments about how much these conflicting indicators reflect cyclical weakness in the job market versus structural factors that would be less easily remedied with monetary policy.

An accurate measure of economic slack is key to properly calibrate monetary policy. Two traditional gauges of slack have become harder to interpret since the Great Recession: the gap between output and its potential level, and the deviation of the unemployment rate from its natural rate. As a consequence, conventional policy rules based on these measures of slack generate wide-ranging policy rate recommendations. This variability highlights one of the challenges policymakers currently face.

Although inflation is currently low, some commentators fear that continued highly accommodative monetary policy may lead to a surge in inflation. However, projections that account for the different policy tools used by the Federal Reserve suggest that inflation will remain low in the near future. Moreover, the relative odds of low inflation outweigh those of high inflation, which is the opposite of historical projections. An important factor continuing to hold down inflation is the persistent effects of the financial crisis.

Over the past two years, both monetary and fiscal policy projections have been based on the view that declines in the long-run potential growth rate of the economy will in turn push down interest rates. In contrast, examination of private-sector professional forecasts and historical data provides little evidence of such a linkage. This suggests a greater risk that future interest rates may be higher than expected.

The housing sector has been one of the weakest links in the economic recovery, and the latest data continue to show only modest improvement. One obstacle to a pickup in housing demand has been tight mortgage credit standards. Indeed, loan standards for borrowers with lower credit scores have shown few signs of easing. Still, as the share of new mortgages financed in the private market has started to rise, access to credit may improve.

The Federal Reserve is on track to end asset purchases in the near future and has laid the groundwork for its plan to eventually normalize monetary policy by raising short-term interest rates. The process of policy normalization is unlikely to start soon, however, and its exact timing will depend on further improvements in unemployment, wages, and inflation. The following is adapted from a presentation by the president and CEO of the Federal Reserve Bank of San Francisco to business and community leaders in Las Vegas, Nevada, on October 9, 2014.

Financial liberalization in China has broad implications, including changing how its central bank’s monetary policy affects the nation’s economy. An estimate of Chinese economic activity and inflation based on a broad set of indicators suggests that the way policy is transmitted to China’s economy has become more like Western market economies in the past decade. Although Chinese monetary policy may actually have exacerbated its economic downturn during the global financial crisis, a move toward stimulatory policy has helped ease its slower growth more recently.

Forecasts of short-term interest rates that are based on futures rates in financial markets can be very misleading when the policy rate is near the zero lower bound. By contrast, options on future short-term interest rates can provide more accurate projections. Currently these options suggest that the federal funds rate—the Federal Reserve’s key monetary policy interest rate—is most likely to lift off from zero around mid-2015 and rise only slowly afterwards at a pace of about 1 percentage point per year.

Because the health sector makes up a large share of the U.S. economy, widespread price changes for medical services can impact overall inflation significantly. Cuts to public health-care spending spill over directly and indirectly to private spending. A recent estimate suggests the full effect of the Medicare payment cuts from the 2011 Budget Control Act resulted in a decline of 0.24 percentage point in the overall personal consumption expenditures price index. This is over twice the expected drop if private-sector spillovers are not included.

An ongoing concern has been that the public might misconstrue the Fed’s forward guidance about future monetary policy and underappreciate the extent to which short-term interest rates may vary with future news about the economy. Evidence based on surveys, market expectations, and model estimates show that the public seems to expect a more accommodative policy than Federal Open Market Committee participants. The public also may be less uncertain about these forecasts than policymakers.

A new volume, Prospects for Asia and the Global Economy, summarizes the 2013 Asia Economic Policy Conference hosted by the Federal Reserve Bank of San Francisco’s Center for Pacific Basin Studies. The conference focused on challenges faced by policymakers in advanced and emerging economies as they continue to recover from the recent global financial crisis. Issues discussed included the monetary policy spillovers from advanced economies to emerging markets, the costs and benefits of foreign reserve accumulation, and the desirability of macroprudential interventions, restrictions on cross-border capital flows, and financial regulatory reforms to reduce the likelihood of future crises.

Highway spending in the United States between 2008 and 2011 was flat, despite the serious need for improvements and the big boost to state highway funds from the Recovery Act of 2009. A comparison of how much different states received and spent shows that these federal grants actually boosted highway spending substantially. However, this was offset by pressures to reduce state highway spending due to plummeting tax revenues. In fact, analysis suggests national highway spending would have fallen roughly 20% over this period without federal highway grants from the Recovery Act.

Historically, businesses in most countries have not been able to sell bonds denominated in their home currencies to foreign investors. In recent decades this trend has been changing. Research shows that bonds denominated in currencies other than the major global currencies have increased, particularly following the global financial crisis. However, not all countries were affected equally. Countries that were able to take advantage of the temporary disruption and near-zero interest rates in global financial markets were the ones with a combination of low government debt and a history of stable inflation.

Following the 2007–09 financial crisis, bank lending to businesses plummeted. Five years later, the dollar amount of bank commercial and industrial lending has finally surpassed the previous peak. However, despite very accommodative monetary policy and abundant excess reserves in the banking system, the spread of the commercial loan interest rates over the target federal funds rate remains above its long-run average. This suggests that business loans are not yet cheap relative to banks’ funding cost.

Median starting wages of recent college graduates have not kept pace with median earnings for all workers over the past six years. This type of gap in wage growth also appeared after the 2001 recession and closed only late in the subsequent labor market recovery. However the wage gap in the current recovery is substantially larger and has lasted longer than in the past. The larger gap represents slow growth in starting salaries for graduates, rather than a shift in types of jobs, and reflects continued weakness in the demand for labor overall.

The 2007–09 financial crisis drew attention to the nature and consequences of connections among financial firms. New reporting standards set in the wake of the crisis have shed more light on these ties in current financial markets. New data are available on the magnitude of risk exposure and the types of collateral that link bank holding companies with their trading partners in over-the-counter derivatives markets. The data show that both the level of risk and diversity of collateral involved in these contracts vary widely depending on the type of counterparties.

Start-ups typically create jobs so fast at the beginning of recoveries that even a modest drop in that pace can affect the whole economy. In fact, slower job growth among new businesses may have resulted in 760,000 fewer jobs in the first year of the current recovery. Because housing wealth is an important factor in the financing of new businesses, lower house prices may have been partly to blame for the slower growth. Conversely, recently increasing house prices may already be boosting start-up growth and, with it, overall job growth.

The well-known Phillips curve suggests that future inflation depends on current and past inflation and a measure of economic slack or resource utilization. Using the unemployment gap to measure slack, a simple Phillips curve currently predicts that inflation will remain quite low through 2015. Two variations of the model, which impose a higher anchor for inflation expectations or focus only on a short-term unemployment gap, still predict that inflation will remain low, albeit higher than implied by the basic model.

Helping the public understand how monetary policy is conducted is an important goal for the Federal Reserve. One way to measure people’s understanding is through surveys that show household expectations for the economy. Responses from the Michigan survey show some groups of households appear to hold beliefs consistent with basic features of U.S. policy. In particular, households with higher incomes and more education appear to better grasp how interest rates relate to inflation and unemployment, particularly during times of labor market weakness.

The very real and sizable costs of using monetary policy to deal with risks to financial stability—along with the uncertain benefits of doing so—argues for finding alternative tools with more favorable tradeoffs. Policymakers should study ways to design policy frameworks that support financial stability, with only a modest cost to macroeconomic goals and anchoring inflation expectations. The following is adapted from a presentation by the president and CEO of the Federal Reserve Bank of San Francisco at the conference “Housing Markets and the Macroeconomy: Challenges for Monetary Policy and Financial Stability” in Eltville am Rhein, Germany, on June 5, 2014.

Monetary policy is moving slowly and cautiously towards normalization. Signs of improvement—falling unemployment, better financial conditions, and abating headwinds—indicate the United States is changing from extraordinary economic times back to ordinary ones. Risks to the recovery’s momentum linger, and “normalizing” should not be confused with “tightening.” Monetary policy will remain highly accommodative for some time. Overall, however, the outlook is positive. The following is adapted from a presentation by the president and CEO of the Federal Reserve Bank of San Francisco to the Association of Trade and Forfaiting in the Americas in San Francisco on May 22, 2014.

Sales of existing homes slowed noticeably over the second half of 2013, reflecting a more drawn-out recovery than expected for housing markets. A main reason for the slowdown is higher mortgage rates that have made financing more costly nationwide. Sales appear to be slowing even more in distressed markets, where real estate investors had bought up single-family homes to convert into rental properties following the housing bust. Evidence suggests that investors may be retreating from these markets as housing valuations rise.

Prices of special financial instruments called inflation derivatives can provide valuable insight into investors’ views of future inflation. Projections from inflation swap rates suggest inflation will remain low for some time and return only slowly to levels consistent with the Federal Reserve’s notion of price stability. Inflation caps and floors give evidence that investors seem less uncertain about inflation forecasts than in recent years, and that they perceive a favorable inflation outcome as increasingly likely.

Earning a four-year college degree remains a worthwhile investment for the average student. Data from U.S. workers show that the benefits of college in terms of higher earnings far outweigh the costs of a degree, measured as tuition plus wages lost while attending school. The average college graduate paying annual tuition of about $20,000 can recoup the costs of schooling by age 40. After that, the difference between earnings continues such that the average college graduate earns over $800,000 more than the average high school graduate by retirement age.

The traditional relationship between unemployment and output growth known as Okun’s law appeared to break down during the Great Recession. This raised the question of whether this rule of thumb was still meaningful as a forecasting tool. However, recent revisions to GDP data show that its relation with unemployment followed a fairly typical cyclical pattern compared with past deep recessions and slow recoveries. The comparatively common patterns suggest that rumors of the death of Okun’s law during the Great Recession were greatly exaggerated.

Before the 2007–09 crisis, standard risk measurement methods substantially underestimated the threat to the financial system. One reason was that these methods didn’t account for how closely commercial banks, investment banks, hedge funds, and insurance companies were linked. As financial conditions worsened in one type of institution, the effects spread to others. A new method that more accurately accounts for these spillover effects suggests that hedge funds may have been central in generating systemic risk during the crisis.

The Great Recession led to large increases in unemployment rates and unemployment durations for workers of all ages, but durations rose far more for older workers than for younger workers. This difference was apparent both during and after the recession, fueling speculation that age discrimination played a role. Research indicates that in states with stronger age discrimination protections, older-worker unemployment durations increased more relative to increases for younger workers. This suggests that state age discrimination laws may need to be modified to strengthen protections during downturns.

Some types of jobs lost during recessions are never recovered, which suggests some unemployed workers must change careers. However, data on hiring during recessions shows the fraction of unemployed workers who change their industry or occupation declines rather than increases. This reflects in part that, when unemployment is high, employers can find applicants with qualifications that closely match job openings. Thus, the rate of overall job growth affects the pace of job market recoveries more than the need for workers to reallocate across sectors.

The Federal Reserve has purchased a large amount of longer-term bonds since December 2008. While these purchases have helped support a strengthening economy, the Fed’s resulting financial position may incur significant declines in bond values and net income when interest rates rise. However, analyzing a range of possible future interest rate scenarios—and their associated probabilities—shows that potential losses associated with these declines are very likely to be manageable.

Recovery from a recession triggered by a financial crisis is greatly influenced by the government’s fiscal position. A financial crisis puts considerable stress on the government’s budget, sometimes triggering attacks on public debt. Historical analysis shows that a private credit boom raises the odds of a financial crisis. Entering such a crisis with a swollen public debt may limit the government’s ability to respond and can result in a considerably slower recovery.

In 2013, the Federal Reserve publicly described conditions for scaling back and ultimately ending its highly accommodative monetary policy. Some emerging market countries subsequently experienced sharp reversals of capital inflows, resulting in sizable currency depreciation. But others did not. Variations in financial market reactions from one country to another appear to have been related to differences in economic conditions, which partly reflected a country’s policies before the Fed’s tapering comments.

In response to job losses associated with the Great Recession, a number of states adopted hiring credits to encourage employers to create jobs. These credits provide tax breaks to employers that create jobs or expand payrolls, with the aim of increasing hiring by reducing labor costs. The evidence on their effects is mixed, although some of these credits appear to have succeeded in boosting job growth.

U.S. Treasury yields and other interest rates increased in the months leading up to the Federal Reserve’s December 2013 decision to cut back its large-scale bond purchases. This increase in rates probably at least partly reflected changes in what bond investors expected regarding future monetary policy. Recent research on this episode tentatively suggests that investors moved earlier the date when they believed the Fed would exit its zero interest rate policy, even though Fed policymakers made few changes in their projections of appropriate monetary policy.

China’s household saving rate has risen substantially during the past two decades. Research suggests that increased job uncertainty following reforms and massive layoffs in state-owned enterprises during the late 1990s contributed significantly to the increase. Facing higher unemployment risks after the reforms, workers in state-owned enterprises have tended to save more as a precaution. A recent study estimates that precautionary saving driven by the reforms explains about a third of Chinese urban household wealth accumulation from 1995 to 2002.

The economic outlook is increasingly positive, boosted by housing, banking, and labor market improvements. While the Federal Reserve recently eased its bond-buying program, indicating monetary policy is on the path back to normal, full normalization will take time and be based on economic data. The following is adapted from a presentation by the president and CEO of the Federal Reserve Bank of San Francisco to Lambda Alpha International and the Arizona Bankers Association in Phoenix, Arizona, on January 7, 2014.

During the past decade’s housing boom, borrowers with lower credit ratings were more likely than higher-rated borrowers to choose adjustable-rate mortgages. This raises the question of whether, amid rapidly rising house prices, lower-rated borrowers paid less attention to loan pricing and interest-rate-related factors. However, even accounting for house price appreciation, research shows these borrowers were as, if not more, responsive as higher-rated borrowers to changes in interest-rate-related fundamentals. Their tendency to choose adjustable-rate mortgages is consistent with mortgage decisions based on economic considerations, rather than just lack of financial sophistication.

2013

The impact of the global financial crisis on labor markets varied widely from country to country. In the United States, the unemployment rate nearly doubled from its pre-recession level. The rate rose much less in the United Kingdom and barely changed in Germany, despite larger declines in gross domestic product. Institutional and technological changes since the 1970s had previously made relationships between output and unemployment more homogeneous across countries. But the global financial crisis undid much of this convergence as countries adopted different labor market policies to adjust output.

Inflation as measured by the personal consumption expenditures price index is near historical low levels, below the Federal Reserve’s 2% longer-run goal. Another common inflation measure, the consumer price index, is also historically low, but remains closer to 2%. The recent gap between these two measures is due largely to the cost of shelter, which makes up a larger proportion of the CPI consumption basket. Based on history, the gap between the two inflation measures should close at a rate of 0.05 percentage point per month.

Taxes collected by the U.S. government are paid out through transfers that promote economic equity among states. This system redistributes funds between richer and poorer states over the long run and helps stabilize states hit by temporary economic shocks. Surprisingly, little if any of this redistribution and stabilization comes from transfer payments through federal programs and services. Rather, differences across states in federal tax payments drive these effects. Research suggests a similar system of taxes and transfers in the European Union could have reduced recent economic divergence among member states.

Financial markets and professional forecasters expect central banks to hit their inflation targets. But U.S., British, and Japanese consumers expect inflation to be higher. Data suggest that consumers in these countries don’t pay attention to central bank inflation targets and react sluggishly to persistent shifts in the inflation rate. However, the price of oil apparently influences inflation expectations strongly. It’s possible that consumers use highly volatile oil prices in a rule of thumb for updating their inflation expectations.

The Federal Reserve has indicated that it may raise the federal funds rate from its current value near zero in 2015. This forward policy guidance is broadly consistent with expectations from business surveys on the most likely timing for the funds rate liftoff. It also appears in line with estimates of policy liftoff from forward interest rates derived from Treasury yields. However, in interpreting forward rates, it is important to account for the zero lower bound on interest rates.

China and the United States are both facing challenges in rebalancing their economies for the future. There are parallels and contrasts, but both face the difficult challenge of maintaining growth today while moving toward a new normal of longer-run economic health for tomorrow. The following is adapted from a presentation by the president and CEO of the Federal Reserve Bank of San Francisco to the Committee of 100 in Los Angeles, California, on November 8, 2013.

Certain financial instruments provide information on expectations of future interest rate movements. One relatively new instrument is yield curve options, which allow investors to take financial positions on a range of possible future interest rates. These options can shed light on the views of financial markets regarding future monetary policy at a time when short-term interest rates are near zero.

Inventories of homes for sale have been slow to bounce back since the 2007–09 recession, despite steady house price appreciation since January 2012. One probable reason why many homeowners are not putting their homes on the market is that their properties may still be worth less than the value of their mortgages, which would leave them owing additional money after a sale. In other cases, homeowners may simply be hoping that house prices will continue to rise, allowing them to recover lost equity.

Federal Reserve policymakers are watching a broad set of indicators for signs of “substantial” labor market improvement, a key consideration for beginning to scale back asset purchases. One way to find which are most useful is to focus on how well movements in these indicators predict changes in the unemployment rate. Research suggests that six indicators are most promising. They offer evidence that the recovery has more momentum now than a year ago, a strong signal that the labor market is improving and could accelerate in coming months.

Unconventional monetary policies such as asset purchases and forward policy guidance have given the Federal Reserve much-needed tools when the traditional policy interest rate is near zero. Looking ahead to normal times, certain types of unconventional policies are best kept in reserve. If another situation arises where the Fed needs to call on these tools, it is ready and prepared to do so. The following is adapted from a presentation by the president and CEO of the Federal Reserve Bank of San Francisco to the UC San Diego Economic Roundtable in San Diego, California, on October 3, 2013.

The Federal Reserve lowered its traditional monetary policy instrument, the federal funds rate, to essentially zero in December 2008. However, economic activity generally depends on interest rates with longer maturities than the overnight fed funds rate. Research shows that interest rates with maturities of two years or more were largely unconstrained by the zero lower bound until at least late 2011. This suggests that, despite the zero bound, the Fed has been able to continue conducting monetary policy through medium- and longer-term interest rates by using forward guidance and large-scale asset purchases.

Standard asset price models have generally failed to detect bubbles, with enormous costs to the economy. Economists are now creating promising new models that account for bubbles by relaxing the assumption of rational expectations and allowing people’s decisions to be driven by their perceptions of what the future may hold. The following is adapted from a presentation by the president and CEO of the Federal Reserve Bank of San Francisco to the National Association for Business Economics in San Francisco, California, on September 9, 2013.

Small businesses have historically contributed more than their share to overall employment growth in the United States. But during the recent recession, the rate of net employment losses of small businesses exceeded that of larger businesses. Sharp cuts in the rate of gross job gains at small businesses appear to have been a major factor explaining the larger net employment losses for this group. The drop in the rate of job gains reflected slower business creation and a lower rate of hiring among expanding small businesses.

The U.S. federal government’s program that provides cash benefits to low-income families with a disabled child has grown rapidly over the past 25 years. This growth reflects changes in the implementation of the program rather than declines in children’s health or family income. Unfortunately, most disabled children from families that receive such benefits do not become employed when they grow up, so these policy changes may relegate these children to lifetime government support—probably near the poverty threshold—at the expense of taxpayers.

Part-time work spiked during the recent recession and has stayed stubbornly high, raising concerns that elevated part-time employment represents a “new normal” in the labor market. However, recent movements and current levels of part-time work are largely within historical norms, despite increases for selected demographic groups, such as prime-age workers with a high-school degree or less. In that respect, the continued high incidence of part-time work likely reflects a slow labor market recovery and does not portend permanent changes in the proportion of part-time jobs.

Investor aversion to risk varies over the course of the economic cycle. In the current recovery, the rebound in risk-taking is near the top of the historical range. The pace of economic growth does not appear to explain the increase in risk appetite. However, statistical research suggests that the severity of the preceding recession explains about 20% of the change in a measure of the long-term stock price-earnings ratio. And corporate profit growth appears to explain about 40% of the decline in the spread between risky and risk-free bonds.

The Federal Reserve’s large-scale purchases of long-term Treasury securities most likely provided a moderate boost to economic growth and inflation. Importantly, the effects appear to depend greatly on the Fed’s guidance that short-term interest rates would remain low for an extended period. Indeed, estimates from a macroeconomic model suggest that such interest rate forward guidance probably has greater effects than signals about the amount of assets purchased.

Since 2009, U.S. job vacancies have increased but unemployment has fallen more slowly than in past recoveries. There is evidence that heightened uncertainty about economic policy has been an important factor behind this change. Increased uncertainty may discourage businesses from filling vacancies, thereby raising unemployment. An estimate indicates that, without policy uncertainty, the unemployment rate in late 2012 would have been close to 6.5%, 1.3 percentage points lower than the actual rate.

After the Great Recession, the fraction of U.S. workers whose wages were frozen reached a record high. Many employers would have preferred to cut wages, but couldn’t do so because of the reluctance of workers to accept reduced compensation. These pent-up wage cuts initially propped up wage growth, reduced hiring, and pushed up unemployment. But, over the past 2½ years, inflation has eroded the real value of frozen wages, slowing wage growth and reducing the unemployment rate. This is similar to, but more pronounced than, the pattern observed in past recessions.

Long-term U.S. government bond yields have trended down for more than two decades, but identifying the source of this decline is difficult. A new methodology suggests that reductions in long-run expectations of inflation and inflation-adjusted interest rates have played a significant role in the secular decline in yields. In contrast, standard statistical finance methods appear to overemphasize the effects of lower risk premiums and reduced uncertainty about future inflation.

The U.S. economy is well into a period of sustained expansion, raising questions about when the Federal Reserve will cut back or end its stimulatory asset purchase program. Such moves will be appropriate at some point, but it’s still too early to act. The timing of any program adjustments will depend on incoming economic data. The following is adapted from a presentation by the president and CEO of the Federal Reserve Bank of San Francisco to the Sonoma County Economic Development Board in Rohnert Park, California, on June 28, 2013.

Social Security Disability Insurance is projected to be insolvent before the end of the decade. How best to restore the program to long-term financial health depends on what has been driving its rapid growth. Demographic shifts and other predictable factors explain part of the increase. But a sizable share reflects increasing participation in the program across population groups. Curbing this growth is important for putting the program back on a sustainable fiscal path.

Federal fiscal policy during the recession was abnormally expansionary by historical standards. However, over the past 2½ years it has become unusually contractionary as a result of several deficit reduction measures passed by Congress. During the next three years, we estimate that federal budgetary policy could restrain economic growth by as much as 1 percentage point annually beyond the normal fiscal drag that occurs during recoveries.

The economy and the labor market have improved substantially since the Federal Reserve started its current $85 billion monthly asset purchase program last September. However, it will take further gains to demonstrate that the “substantial improvement” test for ending Fed asset purchases has been met. The following is adapted from a presentation by the president and CEO of the Federal Reserve Bank of San Francisco at the Portland Business Journal’s CFO of the Year Awards Luncheon in Portland, Oregon, on May 16, 2013.

The most recent U.S. recession and recovery have been accompanied by a sharp decline in the labor force participation rate. The largest declines have occurred in states with the largest job losses. This suggests that some of the recent drop in the national labor force participation rate could be cyclical. Past recoveries show evidence of a similar cyclical relationship between changes in employment and participation, which could portend a moderation or reversal of the participation decline as the current recovery continues.

The Federal Reserve was created 100 years ago in response to the harsh recession associated with the Panic of 1907. Comparing that recession with the Great Recession of 2007–09 suggests the Fed can mitigate downturns to some extent. A statistical analysis suggests that if a central bank had lowered interest rates during 1907 panic the same way the Fed did during the 2008 financial crisis, gross domestic product would have contracted two percentage points less than it actually did.

Commercial real estate construction faltered during the 2007 recession and has improved only slowly during the recovery. However, low interest rates have led to higher property valuations and are clearly benefiting the sector. The recovery of commercial property prices has been notable. Some measures suggest that, in some segments of the market, prices are close to their pre-recession highs. Valuation measures do not suggest that current prices are excessive.

California job growth over the past two decades has been relatively anemic compared with gains in the rest of the country. Nevertheless, economic output has grown faster in California than in the rest of the United States. One factor underlying this pattern may be the growth of higher-wage jobs in California, which has contributed more to output than to employment growth. This creates relatively few opportunities for low-skilled workers, which may help explain why poverty increased more in California than in most states over the period.

Why are the prices of stocks and other assets so volatile? Efficient capital markets theory implies that stock prices should be much less volatile than actually observed, reflecting an unrealistic assumption that investors are risk neutral. If instead investors are assumed to be risk averse, predicted volatility is higher. However, models that incorporate investor avoidance of risk can explain real-world stock price volatility only under levels of risk aversion that are unrealistically high. Thus, price volatility remains unexplained.

Although the Federal Reserve does not target the dollar, its announcements about monetary policy changes can affect the dollar’s exchange value. Before the 2007-09 financial crisis, the dollar’s value generally fell when the Fed lowered its target for the federal funds rate. Since the crisis, the Fed’s announcements of monetary policy easing through unconventional means have had similar effects on the dollar’s exchange rate.

Some commentators have questioned whether China’s economy slowed more in 2012 than official gross domestic product figures indicate. However, the 2012 reported output and industrial production figures are consistent both with alternative Chinese indicators of the country’s economic activity, such as electricity production, and trade volume measures reported by non-Chinese sources. These alternative domestic and foreign sources provide no evidence that China’s economic growth was slower than official data indicate.

Medical-care expenditures have been rising rapidly and now represent almost one-fifth of all U.S. economic activity. An analysis of the privately insured health-care market from 2003 to 2007 indicates that higher prices for medical services contributed largely to nominal spending growth, but did not greatly exceed general overall inflation. In addition, the quantity of services consumed per episode of treatment did not grow during this period. Instead, most of the rise in inflation-adjusted medical-care spending reflected a higher percentage of insurance enrollees receiving treatment.

Economic mobility is a core principle of the American narrative and the basis for the American Dream. However, research suggests that the United States may not be as mobile as Americans believe. The United States has high absolute mobility in the sense that children readily become richer than their parents. But the nation appears to fall short on relative mobility, which is the ability of children to change their rank in the income distribution relative to their parents.

The primary reason unemployment remains high is a lack of demand. An aggregate demand shortfall is exactly the kind of problem monetary policy can address. Thus, we need powerful and continuing monetary stimulus to move toward maximum employment and price stability. The following is adapted from a presentation by the president and CEO of the Federal Reserve Bank of San Francisco to The Forecasters Club in New York, New York, on February 21, 2013.

What explains the sharp decline in U.S. employment from 2007 to 2009? Why has employment remained stubbornly low? Survey data from the National Federation of Independent Businesses show that the decline in state-level employment is strongly correlated with the increase in the percentage of businesses complaining about lack of demand. While business concerns about government regulation and taxes also rose steadily from 2008 to 2011, there is no evidence that job losses were larger in states where businesses were more worried about these factors.

U.S. labor market conditions have improved over the past few years. But the average duration of unemployment has remained very high, suggesting that job prospects for the long-term unemployed have stagnated. However, a closer look at the data indicates that the incidence of long-term unemployment has declined over the past few years, and that job prospects for the long-term unemployed are not as downbeat as the average duration data suggest.

The Federal Reserve has taken bold steps this past year, both in the approaches to stimulate the economy and the way it talks about policy. The Fed’s initiatives are working, and represent the best course to move toward maximum employment and price stability. The following is adapted from a presentation by the president and CEO of the Federal Reserve Bank of San Francisco to the Semiconductor Materials and Equipment International (SEMI) 2013 Industry Strategy Symposium, in Half Moon Bay, California, on January 14, 2013.

The countries of the European periphery are experiencing a balance of payments crisis stemming from persistent current account deficits and sharply lower private capital inflows, a condition known as a sudden stop. In countries with fixed exchange rates, sudden stops typically drain foreign reserves, forcing currency depreciation which eventually shifts the current account from deficit to surplus. However, the sudden stop has not prompted the European periphery countries to move toward devaluation by abandoning the euro, in part because capital transfers from euro-area partners have allowed them to finance current account deficits.

2012

Market expectations about the Federal Reserve’s policy rate involve both the future path of that rate and the uncertainty surrounding that path. Fed policy actions have historically been preceded by high levels of uncertainty, which decline after the policy is made public. Recently, measures of near-term interest rate uncertainty have fallen to historical lows, due partly to a Fed policy rate near zero. Unconventional monetary policies have substantially lowered both expectations and uncertainty about the future path of the Fed’s policy rate.

In January, the U.S. Bureau of Labor Statistics significantly reduced its projections for medium-term labor force participation. The revision implies that recent participation declines have largely been due to long-term trends rather than business-cycle effects. However, as the economy recovers, some discouraged workers may return to the labor force, boosting participation beyond the Bureau’s forecast. Given current job creation rates, if workers who want a job but are not actively looking join the labor force, the unemployment rate could stop falling in the short term.

Federal highway grants to states appear to boost economic activity in the short and medium term. The short-term effects appear to be due largely to increases in aggregate demand. Medium-term effects apparently reflect the increased productive capacity brought by improved roads. Overall, each dollar of federal highway grants received by a state raises that state’s annual economic output by at least two dollars, a relatively large multiplier.

After the federal funds rate target was lowered to near zero in 2008, the Federal Reserve has used two types of unconventional monetary policies to stimulate the U.S. economy: forward policy guidance and large-scale asset purchases. These tools have been effective in pushing down longer-term Treasury yields and boosting other asset prices, thereby lifting spending and the economy. The following is adapted from a presentation by the president and CEO of the Federal Reserve Bank of San Francisco at the University of California, Irvine, on November 5, 2012.

Rapid house price appreciation during the housing boom significantly influenced homebuyer selection of adjustable-rate mortgages over fixed-rate mortgages. In markets with high house price appreciation, house price gains directly influenced mortgage choice. But in markets with less appreciation, price gains did not influence borrower choices between adjustable or fixed-rate mortgages. In addition, the influence of fundamental drivers of mortgage choice, such as mortgage interest rate margins, tended to be muted in markets with high price appreciation.

Borrowers who default on mortgages return to the mortgage market at extremely slow rates. Only about 10% of borrowers with a prior serious delinquency regain access to the mortgage market within 10 years of their default. Borrowers who terminate mortgages for reasons other than default return to the market about two-and-a-half times faster than those who default. Renewed access to credit takes even longer for subprime borrowers with a serious delinquency on their record.

Many analysts have predicted that a Chinese economic slowdown is inevitable because the country is approaching the per capita income at which growth in other countries began to decelerate. However, China may escape such a slowdown because of its uneven development. An analysis based on episodes of rapid expansion in four other Asian countries suggests that growth in China’s more developed provinces may slow to 5.5% by the close of the decade. But growth in the country’s less-developed provinces is expected to run at a robust 7.5% pace.

Progress reducing unemployment has nearly stalled, while annual inflation has fallen below the Federal Reserve’s 2% target. To move toward maximum employment and price stability, the Fed recently announced plans to purchase more mortgage-backed securities and extend its commitment to keep its benchmark interest rate exceptionally low through mid-2015. Thanks partly to these actions, the recovery should gain momentum. The following is adapted from a presentation by the president and CEO of the Federal Reserve Bank of San Francisco at the City Club of San Francisco on September 24, 2012.

One measure of a successful monetary policy is its ability to anchor expectations about future inflation rates. Financial crises, such as that of 2008–09, can be considered natural experiments that test this anchoring. The effects of the crisis on inflation expectations were largely temporary in the United States, but longer-lasting in the United Kingdom. That is surprising because the United Kingdom had a formal inflation target during this period. Expectations may have been affected more because inflation stayed above the central bank’s target for extended periods following the crisis.

Heightened uncertainty acts like a decline in aggregate demand because it depresses economic activity and holds down inflation. Policymakers typically try to counter uncertainty’s economic effects by easing the stance of monetary policy. But, in the recent recession and recovery, nominal interest rates have been near zero and couldn’t be lowered further. Consequently, uncertainty has reduced economic activity more than in previous recessions. Higher uncertainty is estimated to have lifted the U.S. unemployment rate by at least one percentage point since early 2008.

Indexes that rank state business climates figure prominently in debates about economic policy. But empirical evidence is rarely examined on which index factors actually correlate with economic growth. A statistical analysis suggests that state business climate indexes that focus on taxes and business costs are more closely associated with growth than indexes that measure productivity and quality of life. However, these business climate elements are less important for growth than nonpolicy factors, such as climate and population density.

Total business loans under $1 million held by small U.S. banks continue to dwindle. Disproportionate negative growth at financially weak small banks has been an important factor in this decline. Loan volumes at strong small banks actually grew in 2011. The finding supports the view that supply conditions, not just tepid demand for credit, have affected bank lending to small businesses.

A key ingredient of an economic recovery is a pickup in household spending supported by increased consumer debt. As the current economic recovery has struggled to take hold, household debt levels have grown little. Some evidence indicates that households adjusted debt in line with house price movements in their local markets. However, the data show that consumer debt cutbacks were largest among households that defaulted on mortgages or had lower credit scores, suggesting that household borrowing also was restricted by tight aggregate credit supply.

In the wake of the global financial crisis of 2007–08, Asia has emerged as a pillar of financial stability and economic growth. A recent San Francisco Federal Reserve Bank conference focused on Asia’s changing role in the global economy. Asia’s relative strength is allowing it to play an expanded part in multilateral responses to the European sovereign debt crisis. And the reforms put in place following the 1997 Asian financial crisis offer models for countries currently trying to stabilize their economies.

Historically, oil and natural gas prices have moved hand in hand. However, in the past few years, while oil prices climbed to near record peaks, natural gas prices fell to levels not seen since the mid-1970s as a result of new hydraulic fracturing technology. U.S. consumer energy expenditures are still mainly driven by oil prices, so household energy bills got little relief as natural gas prices fell. Moreover, even though the United States has trimmed crude oil imports, they still equal a substantial share of gross domestic product.

The pace of economic growth has been frustratingly slow and the recovery has lost momentum in recent months. The economy is weighed down by the ongoing European sovereign debt crisis and fiscal tightening in our own country. In these circumstances, it is essential that the Federal Reserve provide sufficient monetary accommodation to keep our economy moving towards the central bank’s maximum employment and price stability mandates. The following is adapted from a presentation by the president and CEO of the Federal Reserve Bank of San Francisco to the Idaho, Nevada, and Oregon Bankers Associations on July 9, 2012.

Textbook monetary theory holds that increasing the money supply leads to higher inflation. However, the Federal Reserve has tripled the monetary base since 2008 without inflation surging. With interest rates at historically low levels and the economy still struggling, the normal money multiplier process has broken down and inflation pressures remain subdued. The following is adapted from a presentation by the president and CEO of the Federal Reserve Bank of San Francisco to the Western Economic Association International on July 2, 2012.

Aggregate state, local, and federal fiscal policy was expansionary during the Great Recession and the initial stages of recovery, providing a tailwind to economic growth. Federal fiscal policy in particular was more expansionary than usual, according to a historical analysis, even when the weakness of the economy is taken into account. However, during the past year, aggregate government budgetary policy has reversed course. Over the next few years, as federal fiscal policy shifts toward austerity, it is likely to be a headwind against economic growth.

In the aftermath of the global financial crisis and the Great Recession, research has sought to understand the behavior of house prices. A feature of all bubbles is the emergence of seemingly plausible fundamental arguments that attempt to justify the dramatic run-up in prices. Comparing the U.S. housing boom of the mid-2000s with ongoing Norwegian housing market trends again poses the question of whether a bubble can be distinguished from a rational response to fundamentals. Survey evidence on expectations about house prices can be useful for diagnosing a bubble.

The recent recession and recovery raise important questions about the relative weight of structural and cyclical factors in the economy. A recent San Francisco Federal Reserve Bank conference explored the extent to which different economic variables behaved in a standard cyclical fashion during this episode or were scarred in a more permanent, structural manner. Both cyclical and structural effects appear evident in the recession, suggesting that some features of the U.S. economy can benefit from stimulatory monetary and fiscal policy, while others are more permanently damaged and unlikely to respond to such policies.

The European sovereign debt crisis has created tensions in the global corporate debt market. Investors increasingly hold international assets and companies issue bonds in many countries. Thus, shocks to the European corporate bond market are readily transmitted to the U.S. corporate bond market. However, the rate of transmission is less than one-to-one. Moreover, different segments of the U.S. market vary in the magnitude of their response to European shocks. In particular, higher-rated nonfinancial borrowers and lower-rated financial borrowers are less affected on average.

Past rounds of large-scale asset purchases by the Federal Reserve have lowered yields not only on the targeted securities, but also on various private borrowing rates. In particular, yields on corporate bonds and primary mortgage rates decreased in response to Fed asset purchase announcements. Notably, however, the link between rates on mortgage-backed securities and actual mortgage rates has weakened in the wake of the financial crisis.

The 2007–08 financial crisis was the biggest shock to the banking system since the 1930s, raising fundamental questions about liquidity risk. The global financial system experienced urgent demands for cash from various sources, including counterparties, short-term creditors, and, especially, existing borrowers. Credit fell, with banks hit hardest by liquidity pressures cutting back most sharply. Central bank emergency lending programs probably mitigated the decline. Ongoing efforts to regulate bank liquidity may strengthen the financial system and make credit less vulnerable to liquidity shocks.

Commodity prices have soared several times in recent years, raising concerns that overall inflation could rise substantially. However, crops, oil, and natural gas make up only about 5% of the cost of U.S. consumer goods and services. Thus, about one percentage point of the 10% cumulative inflation since 2007 reflects price rises in these important commodity categories. When the contribution of these commodities is subtracted from overall inflation, the resulting pattern is remarkably similar to that of core inflation, which excludes food and energy prices.

Some observers have argued that the nation’s high unemployment rate during the current recovery stems partly from widespread mismatches between the skills of jobseekers and the needs of employers. A recent San Francisco Federal Reserve Bank conference on workforce skills considered evidence that employers have had difficulties finding workers with appropriate skills in recent years. However, these mismatches do not appear to be much more severe than in the past. Overall, the conference proceedings suggested the U.S. economy can still produce good jobs for workers at a variety of skill levels.

Credit is a perennial understudy in models of the economy. But it became the protagonist in the Great Recession, reviving a role it had not played since the Great Depression. In fact, the central part played by credit in the downturn and weak recovery of recent years is not unusual. A study of 14 advanced economies over the past 140 years shows that financial crises have frequently led to severe and prolonged recessions. Shining the spotlight on credit turns out to be crucial in understanding recent economic events and the outlook.

States that were hit hard by the housing bust performed worse economically during the recession of 2007-09. However, the close relationship between the fall in home prices and state economic activity has largely disappeared during the recovery. High unemployment, restrained demand, and idle production capacity are national in scope. These are just the sorts of problems monetary policy can address. The following is adapted from a speech by the president and CEO of the Federal Reserve Bank of San Francisco at the University of San Diego on April 3, 2012.

Despite a severe recession and modest recovery, real wage growth has stayed relatively solid. A key reason seems to be downward nominal wage rigidities, that is, the tendency of employers to avoid cutting the dollar value of wages. This phenomenon means that, in nominal terms, wages tend not to adjust downward when economic conditions are poor. With inflation relatively low in recent years, these rigidities have limited reductions in the real wages of a large fraction of U.S. workers.

The overall effect of the global financial crisis on emerging Asia was limited and short-lived. However, the crisis affected some countries in the region more than others. Two main crisis transmission channels, exposure to U.S. financial markets and reliance on manufacturing exports, determined how severely countries in the region were affected. Countries that were relatively less connected to global financial markets and relied less on trade fared better and recovered more quickly than countries that were more dependent on global financial and trade markets.

The adverse labor market effects of the Great Recession have intensified interest in policy efforts to spur job creation. The two most direct job creation policies are subsidies that go to workers and hiring credits that go to employers. Evidence indicates that worker subsidies are generally more effective at creating jobs. However, the unique circumstances of recovery from the Great Recession, especially the weak demand for labor, make hiring credits more effective in the short term.

The second round of Federal Reserve large-scale asset purchases, from November 2010 to June 2011, included regular purchases of Treasury inflation-protected securities, or TIPS. An analysis of liquidity premiums indicates that the functioning of the TIPS market and the related inflation swap market improved both on the days the Fed purchased TIPS and over the course of the LSAP program. Thus, TIPS purchases had liquidity benefits beyond the effect they may have had in reducing Treasury yields.

Even in areas that have a common currency, economic conditions can vary greatly from one region to another. So a single uniform monetary policy may not be appropriate. For example, a simple monetary policy rule at times recommends different interest rates for different regions of the United States. Among euro-area countries, such a rule typically recommends an even greater divergence in interest rates, partly due to lower labor mobility, and less use of fiscal transfers to help smooth shocks.

When the housing boom of the past decade turned into a bust, falling house prices played a primary role in driving up delinquency and foreclosure rates. As housing values fell, distressed borrowers lost equity, which hindered their ability to escape delinquency by prepaying their mortgages by refinancing or selling their homes. Falling house prices may have especially impinged on subprime and adjustable-rate borrowers. These homeowners may have counted on being able eventually to refinance into loans with terms more affordable than those of their original mortgages.

The severe global economic downturn and the large stimulus programs that governments in many countries adopted in response have generated a resurgence in research on the effects of fiscal policy. One key lesson emerging from this research is that there is no single fiscal multiplier that sums up the economic impact of fiscal policy. Rather, the impact varies widely depending on the specific fiscal policies put into effect and the overall economic environment.

During the recent recession, unemployment duration reached levels well above those of past downturns. Duration has continued to rise during the uneven economic recovery that began in mid-2009. Elevated duration reflects such factors as changes in survey measurement, the demographic characteristics of the unemployed, and the availability of extended unemployment benefits. But the key explanation is the severe and persistent weakness in aggregate demand for labor.

During the financial crisis of 2007–09, the Federal Reserve took extraordinary steps to stem financial panic. Since then, the Fed has also taken extraordinary action to boost economic growth. The Fed continues to do its level best to achieve its congressionally mandated goals of maximum employment and stable prices. The following is adapted from a speech by the president and CEO of the Federal Reserve Bank of San Francisco at The Columbian’s Economic Forecast Breakfast January 10, 2012, in Vancouver, Washington.

Since 2001, countries around the world have been working on crafting a new global pact to liberalize trade. Despite the difficulties of completing such a multilateral agreement, it remains a worthwhile goal for two reasons. First, a global pact offers cost and efficiency benefits that can’t be achieved under the kinds of agreements among smaller groups of countries that have proliferated in recent years. Second, a global agreement presents a unique opportunity to optimize the use of the world’s resources, thereby improving well-being around the world.

2011

Real estate prices in a local market can be driven by an identifiable group of purchasers. In Hawaii, residents of both the U.S. mainland and Japan have been significant purchasers of homes. An analysis suggests that house prices in Hawaii were driven primarily by purchasers from the U.S. mainland for most of the 1975–2008 period. But, during Japan’s “bubble economy” in the late 1980s and immediately thereafter, house prices in Hawaii were driven primarily by demand from Japan.

Before the global financial crisis of 2007-2009, the United States and several other countries posted large current account deficits. Many of these countries also experienced asset price booms. Evidence suggests the two developments were linked. Rising asset values in the United States permitted households to borrow more easily to boost consumption, while the net sale of debt securities abroad financed current account deficits. The fall in some asset prices since the crisis can make it easier to reduce current account imbalances.

Federal Reserve announcements of future purchases of longer-term bonds may affect asset prices by changing market expectations of the future supply of targeted securities. Such announcements may also affect asset prices by signaling that the stance of conventional monetary policy is likely to remain loose for longer than previously anticipated. Research suggests that these signaling effects were a major contributor to the cumulative declines in Treasury security yields following the eight Fed announcements in 2008 and 2009 about its first round of large-scale asset purchases.

In 2010, statistical experiments based on components of the Conference Board’s Leading Economic Index showed a significant possibility of a U.S. recession over a 24-month period. Since then, the European sovereign debt crisis has aggravated international threats to the U.S. economy. Moreover, the Japanese earthquake and tsunami demonstrated that the U.S. economy is vulnerable to outside disruptions. Updated forecasts suggest that the probability of a U.S. recession has remained elevated and may have increased over the past year, in part because of foreign financial and economic crises.

To understand the effects of news on bond markets, it is instructive to look beyond individual maturities and consider the entire term structure of interest rates. For example, unexpected changes in monthly nonfarm payroll employment numbers cause large movements at short and medium maturities, but do not affect long-term interest rates. Inflation news affects the long end of the term structure. Monetary policy actions vary in their effects on interest rates, but cause volatility at all maturities, including distant forward rates.

The payment landscape has changed dramatically in recent years as new technologies have been brought to market. Yet, the demand for U.S. currency—cold, hard cash—shows no sign of fading. An empirical analysis indicates that alternative payment technologies have tended to keep cash growth in check, but other factors have more than offset this. Over the next 10 years, cash volume is projected to grow 1.7% per year.

Although bank small business loan portfolios continue to shrink, there are hints of possible stabilization. Among smaller banks, small business lending that is not backed by commercial real estate looks slightly healthier than small business lending that is secured by commercial property. Meanwhile, small commercial and industrial loans at larger banks are showing clear signs of a turnaround. Evidence from the 2001 recession as well as loan performance data suggest that small commercial and industrial loans at smaller banks may not be far behind.

Researchers have made great strides in improving our understanding of the effects of unconventional monetary policy. Although further study is needed, the evidence from the past few years demonstrates that both forward guidance and large-scale asset purchases are useful policy tools when short-term interest rates are constrained by the zero bound.

Rising layoff rates during the spring of 2011 highlight renewed labor market weakness. Although job cuts among state and local governments have accelerated over the past few years, most of the recent increase occurred among private-sector employers. Following modest improvement in early summer, subsequent labor market performance has been uneven, indicating that labor market conditions remain fragile.

Commercial real estate capitalization rates have been found to be good indicators of expected returns in commercial properties. Recent declines in these cap rates appear to be signaling a commercial real estate rebound, indicating improved investor expectations of price growth in the market. Movements in national cap rates are the predominant drivers of changes in cap rates in local markets. Therefore, the anticipated commercial real estate rebound is likely to be widespread across many metropolitan areas.

Mergers tend to improve credit union cost efficiency. When the acquirer is much larger than the target credit union, target members benefit in terms of lower loan rates and higher deposit rates, while acquirer members see little change. When merger partners are more equal in size, these benefits are shared more evenly. Over time, credit union mergers have shifted from, on average, only benefiting targets to also benefiting acquirers to some extent.

The recent financial crisis showed that a financial institution’s equity may be sufficient to absorb losses during normal times, but insufficient during periods of systemic distress. In recognition of this risk, the Basel III agreement last year introduced a new element of macroprudential regulation called countercyclical buffers, variable capital requirements that shift based on credit growth. These buffers raise the classic regulatory dilemma of safety versus economic growth, but may provide protection against financial calamity at an acceptable cost.

Historical data indicate a strong relationship between the age distribution of the U.S. population and stock market performance. A key demographic trend is the aging of the baby boom generation. As they reach retirement age, they are likely to shift from buying stocks to selling their equity holdings to finance retirement. Statistical models suggest that this shift could be a factor holding down equity valuations over the next two decades.

Goods and services from China accounted for only 2.7% of U.S. personal consumption expenditures in 2010, of which less than half reflected the actual costs of Chinese imports. The rest went to U.S. businesses and workers transporting, selling, and marketing goods carrying the “Made in China” label. Although the fraction is higher when the imported content of goods made in the United States is considered, Chinese imports still make up only a small share of total U.S. consumer spending. This suggests that Chinese inflation will have little direct effect on U.S. consumer prices.

Recent surges in food and energy prices have pushed up headline inflation to levels well above its underlying trend. In contrast, core inflation, which excludes food and energy prices, has remained low and stable. Historical data suggest that, since the early 1990s, headline inflation has tended to converge toward core inflation. Thus, high inflation is unlikely to persist as long as inflation expectations remain anchored.

Over the past several years, U.S. housing starts have dropped to around 400,000 units at an annualized rate, the lowest level in decades. A simple model of housing supply that takes into account residential mortgage foreclosures suggests that housing starts will return to their long-run average by about 2014 if house prices first stabilize and then begin appreciating, and the bloated inventory of foreclosed properties declines.

Small businesses have relied considerably on securitized markets for credit. The recent financial crisis led to a virtual cessation of securitization of some of the loans used by small businesses, such as commercial real estate mortgages, vehicle, and credit card loans. In addition, values of commercial and residential real estate, which small businesses often use as collateral for loans, dropped dramatically. As a consequence, small businesses may have experienced tighter credit conditions than larger businesses, which rely relatively less on those categories of loans and collateral.

The Great Recession of 2007-2009, coming on the heels of a spending binge fueled by a housing bubble, so far has resulted in over $7,300 in foregone consumption per person, or about $175 per person per month. The recession has had many costs, including negative impacts on labor and housing markets, and lost government tax revenues. The extensive harm of this episode raises the question of whether policymakers could have done more to avoid the crisis.

Stress testing was a potent tool in the supervision of bank capital during the financial crisis. Stress tests can enhance supervision of bank capital by providing a more forward-looking and flexible process for assessing risks that might not be fully captured by risk-based capital standards. The level and quality of capital among large banking organizations has increased notably since the introduction of stress tests during the financial crisis.

Estimating market expectations for inflation from the yield difference between nominal Treasury bonds and Treasury inflation-protected securities—a difference known as breakeven inflation—is complicated by the liquidity differential between these two types of securities. Currently, the extent to which liquidity plays a role in determining breakeven inflation remains contentious. Information from the market for inflation swaps provides a range for the possible liquidity premium in TIPS, which in turn suggests a range for estimates of inflation expectations that is well below the widely followed Survey of Professional Forecasters inflation forecast.

The European Central Bank recently raised its target interest rate for the first time since the 2008 financial crisis. When compared with a simple interest rate rule, this rate hike appears consistent with the euro area’s nascent economic recovery and rising inflation. However, economic conditions vary greatly among the countries in the euro area and the ECB’s new target rate may not be suitable for all of them.

Economics education faces a challenge in keeping up with the changes that have swept through monetary policy in recent decades. Many central banking innovations, such as interest on reserves and large-scale asset purchases, aren’t adequately treated in standard textbooks. The following is adapted from a presentation made by the president and CEO of the Federal Reserve Bank of San Francisco to the AEA National Conference on Teaching Economics and Research in Economic Education in San Francisco on June 1, 2011.

The University of Michigan survey of consumers shows that expected inflation has moved up noticeably over the past few months, raising concerns that we may be in for a period of rising inflation. However, the increase in expected inflation likely reflects the excess sensitivity of consumers to food and energy prices. Consistent with this hypothesis, household surveys have not forecast inflation well in recent years, a period of volatile food and energy prices.

Financial institutions often do not charge explicit fees for the services they provide, but are instead compensated by the spread between interest rates on loans and deposits. The lack of explicit fees in lending makes it difficult to measure the output of banks and other financial institutions. Effective measurement should distinguish between income derived from lending services and income derived from portfolio decisions about risk and duration, and should be consistent among bank and nonbank financial institutions.

Inflation has risen of late, reflecting higher prices for many commodities. The inflation rate is likely to peak around the middle of 2011 and then return to an annual level of about 1¼ to 1½%. A sustained period of high inflation is very unlikely and the Fed will act quickly and decisively to ensure price stability. The following is adapted from a presentation made by the president and CEO of the Federal Reserve Bank of San Francisco to Town Hall Los Angeles on May 4, 2011.

The Federal Reserve’s current large-scale asset purchase program, dubbed “QE2,” has a precedent in a 1961 initiative by the Kennedy Administration and the Federal Reserve known as “Operation Twist.” An analysis finds that four of six potentially market-moving Operation Twist announcements had statistically significant effects and that the program cumulatively caused a significant but moderate 0.15 percentage point reduction in longer-term Treasury yields. These results can be used to estimate QE2’s effects.

While the market for Treasury inflation-protected securities (TIPS) has developed considerably over the past decade, the debate over whether their issuance benefits the U.S. Treasury remains contentious. Information from inflation swap rates in conjunction with a joint model of yields for nominal non-inflation-protected Treasury bonds and TIPS provides evidence that, even under conservative assumptions, the TIPS inflation risk premium has been large enough in recent years to offset the liquidity disadvantage of the series. This suggests that overall the Treasury has benefited from issuing TIPS.

To make financial conditions more supportive of economic growth, the Federal Reserve has purchased large amounts of longer-term securities in recent years. The Fed’s resulting securities portfolio has generated substantial income but may incur financial losses when market interest rates rise. Such interest rate risk appears modest, especially relative to the Fed’s policy objectives of full employment and price stability.

Prices of commodities including metals, energy, and food have been rising at double-digit rates in recent months. Some critics argue that Federal Reserve purchases of long-term assets are fueling this rise by maintaining an excessively expansionary monetary stance. However, daily data indicate that Federal Reserve announcements of large-scale asset purchases tended to lower commodity prices even as long-term interest rates and the value of the dollar declined.

In the recent recession and recovery, the unemployment rates, part-time employment trends, and earnings growth of recent college graduates have closely mirrored the patterns they displayed during the cyclical recession of 2001 and the subsequent jobless recovery. Recent college graduates are typically not subject to structural frictions that can contribute to weak labor markets, such as mismatches between the skills of job seekers and the needs of employers. Similarities in the labor market experiences of recent college graduates in the two recessions and recoveries suggest that the current high unemployment rate is primarily cyclical.

Unexpected events such as job displacement, disability, and divorce can have negative effects on individual and family income. For many families, social insurance provided by the government plays an important role in buffering the impact of these shocks. However, on average, Americans depend more on private resources rather than the public sector to insure against these losses.

The euro area faces its first sovereign debt crisis, highlighting the fiscal imbalances of member countries. Troubled countries are implementing austerity measures, with adjustments focusing on the short and medium run. However, a long-run solution to Europe’s problems requires economic reforms that increase competitiveness and reduce labor costs in the peripheral countries. Such reforms would promote convergence of the euro-area economies and enhance the long-run sustainability of monetary union.

Economists drew a number of lessons from the Asian financial crisis of 1997-98 for preventing such episodes or mitigating their effects. Some of those are similar to lessons drawn from the global financial crisis of 2007-09. But differences in economic development and sophistication of the financial systems of East Asian countries compared with those of the United States and Western Europe made it difficult to apply the lessons of the earlier crisis.

Recent labor markets developments, including mismatches in the skills of workers and jobs, extended unemployment benefits, and very high rates of long-term joblessness, may be impeding the return to “normal” unemployment rates of around 5%. An examination of alternative measures of labor market conditions suggests that the “normal” unemployment rate may have risen as much as 1.7 percentage points to about 6.7%, although much of this increase is likely to prove temporary. Even with such an increase, sizable labor market slack is expected to persist for years.

Initial claims for unemployment insurance averaged a stubbornly high 468,000 in the year ending December 2010, but have recently come down quickly. Many analysts interpret this as a sign that layoffs were too high to support a strong labor market recovery during most of 2010. However, claims data may have exaggerated layoffs in 2010 because the fraction of unemployed workers applying for benefits was higher than before the recession. If the proportion of eligible workers who applied were held constant, 2010 claims would have averaged roughly 20% less than the actual reading.

An analysis shows that the Federal Reserve’s large-scale asset purchases have been effective at reducing the economic costs of the zero lower bound on interest rates. Model simulations indicate that, by 2012, the past and projected expansion of the Fed’s securities holdings since late 2008 will lower the unemployment rate by 1½ percentage points relative to what it would have been absent the purchases. The asset purchases also have probably prevented the U.S. economy from falling into deflation.

The U.S. economic recovery has been weak, especially in employment growth. A microeconomic analysis of U.S. counties shows that this weakness is closely related to elevated levels of household debt accumulated during the housing boom. Counties where household debt grew moderately from 2002 to 2006 have seen a moderation of employment losses and a robust recovery in durable consumption and residential investment. By contrast, counties that experienced large increases in household debt during the boom have been mired in a severe recessionary environment even after the official end of the recession.

In the years since the bursting of the housing bubble, the personal saving rate has trended up from around 1% to around 6%, while the ratio of household debt to disposable income has dropped from 130% to 118%. Changes over time in the availability of credit to households can explain 90% of the variance of the saving rate since the mid-1960s, including the recent uptrend, according to a simple empirical model.

2010

Mortgage lenders impose a default premium on the loans they originate to compensate for the possibility that borrowers won’t make payments. The housing boom of the 2000s was characterized by increasing riskiness of the borrowers approved for mortgages and the structures of the loans themselves. Despite these changes in risk, a pricing model can justify the spreads contained in mortgages made during this period based on what at the time seemed to be reasonable expectations for house price appreciation. Contrary to those expectations, prices fell dramatically.

Financial reform legislation passed by Congress in 2010 requires mortgage originators to retain some loss exposure on the mortgages they securitize. Recent research compares the performance of mortgage-backed securities for different types of issues in which originators retain different degrees of loss exposure. The findings suggest that retention of even modest loss exposure by originators reduces moral hazard and is associated with significantly lower loss rates on these securities.

In recent months, inflation as measured by the personal consumption expenditures price index has been trending lower. This slowdown, known as disinflation, has raised concerns that inflation might actually drop below zero and enter a period of deflation. An examination of the distribution of inflation rates across the range of goods and services that compose the index suggests that downward pressures on inflation are relatively high by historical standards.

The idea that business cycle fluctuations may stem partly from changes in consumer and business confidence is controversial. One way to test the idea is to use professional economic forecasts to measure confidence at specific points in time and correlate the results with future economic activity. Such an analysis suggests that changes in expectations regarding future economic performance are important drivers of economic fluctuations. Moreover, periods of heightened optimism are followed by a tightening of monetary policy.

An increase in U.S. aggregate labor demand reflected in rising job vacancies has not been accompanied by a similar decline in the unemployment rate. Some analysts maintain that unemployed workers lack the skills to fill available jobs, a mismatch that contributes to an elevated level of structural unemployment. However, analysis of data on employment growth and jobless rates across industries, occupations, and states suggests only a limited increase in structural unemployment, indicating that cyclical factors account for most of the rise in the unemployment rate.

Greece’s enormous fiscal deficit and high debt level culminated earlier this year in the euro zone’s first sovereign debt crisis. High yields on Greece’s debt indicate that markets have priced in the possibility of default. Compared with Argentina, which defaulted on its debt in 2001, Greece’s fiscal position is much worse. However, unlike Argentina, Greece is supported by other euro zone countries and is not vulnerable to speculative currency attacks, advantages that offer it some protection from default.

The low level of inflation and the sluggish pace of economic recovery have raised concerns about sustained deflation—an inflation rate below zero with a general fall in prices. However, the relative prices of inflation-indexed and non-indexed Treasury bonds, which historically have proven to be good measures of inflation expectations, suggest that financial market participants consider the probability of deflation to be low.

House prices have fallen approximately 30% from their peak in 2006, accompanied by a level of defaults and foreclosures without precedent in the post-World War II era. Many homeowners have mortgages with principal amounts higher than the market value of their properties. In general, though, the rational default point is below the “underwater” point where house price equals the remaining loan balance, and depends on prospects for future house price appreciation and borrower default costs.

Financial executive pay is a convex function of profits if recipients get a greater increment in pay when returns are high as opposed to moderate, compared with when returns are moderate as opposed to low. Convex compensation packages give financial executives incentive to adopt risky investment projects, implement highly levered capital structures, and create new risk. Financial regulators may be able to enforce changes in compensation that would attenuate these adverse effects.

The current economic recovery is proceeding at a tepid pace despite massive federal fiscal stimulus and extremely low interest rates. Forecasts derived from business cycle indicators produced by the Chicago and Philadelphia Federal Reserve Banks predict that real U.S. GDP growth through the first half of 2011 will remain at or below potential. If these forecasts prove accurate, then the historical relationship between real GDP growth and the labor market suggests that the unemployment rate could rise by as much as 0.5 percentage point during this period.

Productivity growth has been quite strong over the past 2½ years, despite a drop in the second quarter of 2010. Many analysts believe that productivity growth must slow sharply in order for the labor market to recover robustly. However, looking at the observable factors underlying recent productivity growth and the patterns of productivity over past recessions and recoveries, a sharp slowdown appears unlikely.

Although the labor market has slowly begun to recover, unemployment remains stubbornly high. The pace at which unemployment comes down over the next two years depends in part on the cyclical recovery of labor force participation and the extent to which that offsets or adds to ongoing structural changes in labor force behavior related to increased school enrollment, access to disability benefits, and movement of baby boomers into retirement.

The effects of immigration on the total output and income of the U.S. economy can be studied by comparing output per worker and employment in states that have had large immigrant inflows with data from states that have few new foreign-born workers. Statistical analysis of state-level data shows that immigrants expand the economy’s productive capacity by stimulating investment and promoting specialization. This produces efficiency gains and boosts income per worker. At the same time, evidence is scant that immigrants diminish the employment opportunities of U.S.-born workers.

The Federal Reserve Bank of San Francisco’s annual macroeconomics conference focused this year on the theme “Financial Market Imperfections and Macroeconomics.” Conference papers explored the empirical and theoretical performance of the U.S. and international economies before, during, and after a financial crisis. Financial crises are typically associated with severe economic downturns, but monetary policy can help to offset some of these effects. The unconventional monetary policies pursued by many central banks after the most recent crisis may have helped prevent it from becoming much worse.

An unstable economic environment has rekindled talk of a double-dip recession. The Conference Board’s Leading Economic Index provides data for predicting the probability of a recession but is limited by the weight assigned to its indicators and the varying efficacy of those indicators over different time horizons. Statistical experiments with LEI data can mitigate these limitations and suggest that a recessionary relapse is a significant possibility sometime in the next two years.

Downturns in the construction and finance sectors played a significant role in the recent recession. A stock-market-based measure that captures sectoral shocks shows that these disturbances are important for explaining long-duration unemployment. This is consistent with the intuition that sectoral shocks cause workers to engage in time-consuming moves across industries in their searches for work. It also suggests that it will take a while before the more than 1.8 million unemployed construction workers and close to a half million unemployed finance and insurance workers find jobs.

Despite historically low mortgage interest rates, borrower prepayments have been lower than expected over the past year. For example, a model based on prepayment data from 2000 through the beginning of 2009 predicts a prepayment rate for the first quarter of 2010 roughly twice as high as the observed rate. It can be conjectured that current low prepayment rates reflect the influence of factors specific to the housing bust, including a significant tightening of lending terms for certain borrowers, weak housing demand, and high foreclosure rates.

The optimal proportion of financial wealth placed in stocks versus risk-free bonds changes over an investor’s life and is very sensitive to the long-run correlation between stock returns and labor income. If this correlation is assumed to be high, then the optimal proportion of stock is hump-shaped and approximately zero for young agents, in contrast to the claims of financial advisers and most academic models.

The recession that began in late 2007 severely reduced state tax revenue and increased demand for many public services. In the near term, institutional and political factors limit the options states have for cutting spending and raising taxes. Aid to states in the federal economic program is winding down next year and the situation is likely to get worse before it gets better. Painful budgetary choices lie ahead for many states, though the drag on the national economy should be modest.

Financial institutions are increasingly using economic capital models to help determine the amount of capital they need to absorb unexpected losses. These models typically aggregate capital based on business-level analysis. However, important challenges surround this aggregation as well as other aspects of these models. Supervisors could use these capital calculations when they assess capital adequacy, but they need to be aware of these modeling issues.

As the financial crisis has receded, the Federal Reserve has scaled back its extraordinary provision of liquidity. Eventually, the Fed will remove all remaining monetary stimulus by raising the federal funds rate and shrinking its balance sheet. The timing of such renormalizations depends crucially on evolving economic conditions.

Many central banks conduct monetary policy according to an inflation targeting framework, which requires that some measure of inflation be chosen as the target. One approach would be to use an index of goods and services whose prices are market determined and not subject to frequent, idiosyncratic, and transitory changes. That could be an index based on the personal consumption expenditures prices of services and durable goods, excluding nondurable goods, similar to but distinct from the U.S. core personal consumption expenditures price index.

The enormity of the recent financial shock was not fully apparent until well into the crisis. One result was that banks did unusually low levels of pre-reserving against eventual loan losses. Much of that underreserving was related to the extraordinary decline in real estate values that led to outsized losses on mortgage loans. This experience highlights the limitations of the bank provisioning process and the need to guard against worse-than-expected economic conditions through higher capital levels.

Economic recoveries from the past two recessions have been much more gradual than the rapid V-shaped recoveries typical of earlier downturns. Analysis of the factors that determine economic growth rates indicates that recovery from the most recent recession is likely to be faster than from the two previous recessions, but slower than earlier V-shaped recoveries.

The single most important proposition in economic theory, first stated by Adam Smith, is that competitive markets do a good job allocating resources. Vilfredo Pareto’s later formulation was more precise than Smith’s, and also highlighted the dependence of Smith’s proposition on assumptions that may not be satisfied in the real world. The financial crisis has spurred a debate about the proper balance between markets and government and prompted some scholars to question whether the conditions assumed by Smith and Pareto are accurate for modern economies.

This conference examined how the recent economic crisis has changed residential and development environments in many parts of the world. For example, the crisis has reduced home ownership and created pressure to increase neighborhood density in the United States. And, at least temporarily, it slowed migration in China to export-oriented urban areas.

The conference was sponsored by the Center for the Study of Innovation and Productivity and was held at the Federal Reserve Bank of San Francisco November 18, 2009.

During the current labor market downturn, unemployment duration has reached levels well above its previous highs. Analysis of unemployment data suggests that extended unemployment insurance benefits have not been important factors in the increase in the duration of unemployment or in the elevated unemployment rate.

Some analysts have raised the question of whether the unprecedented declines in house values, which have been the hallmark of the recent recession, might be artificially dampening core inflation readings. However, a close examination of recent inflation data shows that the weakness in housing costs is representative of a broad pattern of subdued price increases across most consumption goods and services and is not distorting the broad downward trend in core inflation measures.

A massive structural budget deficit threatens the long-term economic health of the United States. But the fiscal imbalance won’t necessarily fuel inflation as long as the Federal Reserve retains the independence to pursue its objectives of maximum sustainable employment and price stability. The following is adapted from a presentation made by the president and CEO of the Federal Reserve Bank of San Francisco to Town Hall Los Angeles on March 23, 2010.

China is becoming increasingly active in international markets for mergers and acquisitions. Chinese acquirers are buying stakes in foreign companies to get access to resources, markets, and technology, among other reasons. With China’s expanding wealth and vast foreign exchange resources, further growth in the volume and variety of foreign direct investment is likely.

“Asia and the Global Financial Crisis,” the first Asia Economic Policy Conference of the Federal Reserve Bank of San Francisco’s Center for Pacific Basin Studies, examined the impact of the crisis on Asian nations and the responses of policymakers. Although nations in the region were deeply affected, they generally recovered more quickly and vigorously than other industrial and emerging markets thanks to strong economic fundamentals and reforms enacted following financial crises in the 1990s.

In 2009, strong growth in productivity allowed firms to lay off large numbers of workers while holding output relatively steady. This behavior threw a wrench into the long-standing relationship between changes in GDP and changes in the unemployment rate, known as Okun’s law. If Okun’s law had held in 2009, the unemployment rate would have risen by about half as much as it did over the course of the year.

Structural models of default are widely used to analyze corporate bond spreads, but have generally been unable to explain why risk premiums are as high as they are. This credit spread puzzle can be addressed by taking into account such factors as the variability of the level of risk premiums and the likelihood of default over the course of the economic cycle. Models that incorporate such variations over time are more successful at generating spreads consistent with historical observations.

The beginnings and ends of recessions are officially dated about 12 months after the fact. A common rule of thumb declares recessions as two quarters of consecutive negative GDP growth, but this is very inaccurate. A better option is to apply medical diagnostic evaluation methods to the business conditions indexes of the Chicago and Philadelphia Federal Reserve Banks, which suggests the recent recession ended in July or August 2009.

Hong Kong and China are recovering impressively from global recession thanks to effective stimulus programs. But authorities worry that expansionary U.S. monetary policy may fuel asset bubbles in their economies. In the long run, the recession may nudge China toward increased domestic consumption by highlighting the risks of export-driven development. This Letter is adapted from a report by the president and CEO of the Federal Reserve Bank of San Francisco on her visit to Hong Kong and China November 15-21, 2009. Each year, the president of the San Francisco Fed joins the Federal Reserve governor responsible for liaison with Asia on a fact-finding trip to the region, in keeping with the Bank’s objective of developing expertise on issues related to the Pacific Basin.

In the United States throughout 2009, the share of adjustable-rate mortgages among total mortgage originations was very low, apparently reflecting the attractive pricing of fixed-rate mortgages relative to ARMs. Government policy could have changed the relative attractiveness of the fixed-rate mortgages and ARMs, thereby shifting the market share of these two housing finance instruments.

Monetary policymakers have long debated the usefulness of the Phillips curve, which relates inflation to measures of economic slack. Since the recession started in late 2007, evidence suggests that, consistent with the Phillips curve, a high level of unemployment has contributed to a decline in inflation.

Household leverage in the United States and many industrial countries increased dramatically in the decade prior to 2007. Countries with the largest increases in household leverage tended to experience the fastest rises in house prices over the same period. These same countries tended to experience the biggest declines in household consumption once house prices started falling.

2009

The financial crisis has been worldwide in scope, but the severity has differed from country to country. Those countries whose banks played a more central role in the global financial system, were important intermediaries, or had extensive direct relationships tended to be less seriously affected, as measured by the extent of the decline in their stock markets in 2008.

Capital structure theories seek to explain why businesses choose different mixes of debt and equity to finance their operations. Banking firms represent a special case because of certain unique features in the industry, including a federal safety net and extensive regulation. The financial crisis of the past two years provided another set of special circumstances in which banks needed to raise capital. The preference banks have shown for issuing preferred shares in the private market in favor of government financing can be viewed through the lenses of capital structure theories.

The crisis of the past two years has underscored the connections between monetary policy, which seeks to foster maximum employment and price stability, and regulatory policy, which works to protect the financial system. The two domains can’t be regarded as separate. Researchers are currently examining ways in which monetary policy may play a role in managing systemic risk and regulatory policy may serve to promote macroeconomic goals. The following is adapted from a presentation made by the president and CEO of the Federal Reserve Bank of San Francisco to the Institute of Regulation & Risk, North Asia, in Hong Kong on November 17, 2009.

As part of their efforts to promote economic recovery, some central banks have announced they will not raise policy rates for specified time periods. Other central banks have not been as explicit, though they have provided guidance. A comparison of the effects of the Bank of Canada’s conditional promise to hold rates steady through the second quarter of 2010 with the Federal Reserve’s less explicit guidance finds no evidence that market participants make distinctions between these statements.

Predicting the course of inflation is one of the most important challenges facing monetary policymakers. Useful aids to such prediction are the measures of expected future inflation obtained from prices in government bond markets. An examination of recent inflation-indexed and non-indexed U.S. Treasury bond yields suggests that financial market participants believe that the probability of prolonged deflation has become fairly small.

As the U.S. housing market has moved from boom in the middle of the decade to bust over the past two years, the sources of mortgage funding have changed dramatically. The government-sponsored enterprises—Fannie Mae, Freddie Mac, and Ginnie Mae—now own or guarantee an overwhelming share of originations. At the same time, non-agency mortgage securitization and loans retained in lender portfolios have largely dried up.

The Federal Reserve and other central banks have responded to the current financial crisis by taking a range of aggressive policy actions aimed at reviving credit markets. In particular, the Fed has pushed the federal funds rate, its key policy instrument, to historically low levels. Research suggests that overall credit conditions since late 2007 have remained tighter than would have been expected based on historical experience and that this tightness may be partly offsetting the Fed’s policy actions.

Disagreement among economic forecasters about the future path of inflation has risen substantially since the start of the recession. The nature of this disagreement varies with the forecast time horizon, with some forecasters expecting much lower short-run inflation and others anticipating much higher long-run inflation. This variation may complicate the Federal Reserve’s monetary policy communications strategy.

The enormity of the current financial collapse raises the question whether the crisis could have been predicted. This is the second of two Economic Letters on the topic. This Letter examines research suggesting that early warning models would not have accurately predicted the relative severity of the current crisis across countries, casting doubt on the ability of such models to forecast similar crises in the future.

The enormity of the current financial collapse, widely described as a bursting bubble, raises the question whether the crisis could have been predicted, possibly permitting action to offset its effects. In the first of two Economic Letters on the subject, we look at developments in the United States and find evidence suggesting that simple indicators based on asset market developments can provide early warnings about potentially dangerous financial imbalances.

Unemployment insurance benefits have been on an upward trend over the past two decades, partially reversing an earlier decline. The trend is associated with shifts toward a higher share of job losers among the unemployed and longer durations of unemployment, which may cause benefits to lapse for some recipients as labor market weakness persists.

Many credit line agreements contain restrictive covenants and other contingencies that may limit the ability of borrowers to draw on their lines, which is a particular concern to small firms. This Economic Letter reviews recent empirical studies that suggest that private firms’ access to credit lines is much more sensitive to changes in bank lending standards than is access by publicly traded firms.

Total factor productivity—a measure of the efficiency with which labor and capital are used—has fallen during the current recession. But, after adjustment for lower utilization of labor and capital, such productivity has risen strongly over the past two years. These growth–accounting measures suggest that efficiency gains have continued during the recession, boding well for long-term economic growth.

In response to turmoil in the interbank lending market, the Federal Reserve inaugurated programs to bolster liquidity beginning in December 2007. Research offers evidence that these liquidity facilities have helped lower the London interbank offered rate, a key market benchmark, significantly from what it otherwise would have been expected to be.

Since Congress overhauled the U.S. welfare system in 1996, single mothers between 18 and 24 have reduced welfare dependency, increased workforce participation, and registered gains in household income. The group’s growing attachment to the labor force means they may be better positioned to take advantage of unemployment insurance during the current recession.

Papers presented at the conference on “Macroeconomic Models for Monetary Policy” held March 6, 2009, at the Federal Reserve Bank of San Francisco addressed such issues as how to model wage and price behavior and how to measure economic output. The answers to these and other questions examined at the conference are highly relevant for monetary policy and for the macroeconomic models in use at central banks around the world.

The Federal Reserve has responded to a severe recession by developing programs to bolster the financial system and restore economic growth. The Fed has the tools to unwind these programs when appropriate, maintaining price stability. The following is adapted from a speech delivered by the president and CEO of the Federal Reserve Bank of San Francisco to the Commonwealth Club in San Francisco on June 30, 2009.

As policies are proposed to expand health insurance coverage in the United States, it is useful to focus on the experience of Hawaii, where employers are required to offer such insurance to their full-time employees. Our findings suggest that Hawaii’s law has substantially increased health insurance coverage in the state, although the impact has been partially offset by employers’ increased reliance on the exempt class of employees who work fewer than 20 hours per week.

Should fiscal policy be used to fight recessions? Most economists would answer that, for normal economic ups and downs, business cycle stabilization should be left to monetary policy and that fiscal policy should focus on long-term goals.

The output gap measures how far the economy is from its full employment or “potential” level that depends on supply-side factors of the economy: the supply of workers and their productivity. During a boom, economic activity may for a time rise above this potential level and the output gap is positive.

Although the pace of layoffs appears to be subsiding and the overall economy is showing hints of stabilization, most forecasters expect unemployment to continue to increase in coming months and to recede only gradually as recovery takes hold. In this Economic Letter, we evaluate this projection using data on three labor market indicators: worker flows into and out of unemployment; involuntary part-time employment; and temporary layoffs.

The global financial market turmoil that started in August 2007 has been followed by a severe economic downturn. Indeed, the U.S. economic recession is on track to be the longest and deepest of the postwar period.

U.S. household leverage, as measured by the ratio of debt to personal disposable income, increased modestly from 55% in 1960 to 65% by the mid-1980s. Then, over the next two decades, leverage proceeded to more than double, reaching an all-time high of 133% in 2007.

This Economic Letter is adapted from a speech delivered by Janet L. Yellen, president and CEO of the Federal Reserve Bank of San Francisco, to the 18th Annual Hyman P. Minsky Conference on the State of the U.S. and World Economies on April 16, 2009, in New York City.

The American Recovery and Reinvestment Act of 2009 (ARRA) was signed into law on February 17, and already its impact is being felt in state capitals around the nation. Governors and state legislators are incorporating expected stimulus funds into 2009-2010 budgets and a number of state public works projects predicated on ARRA funding already have begun.

Over the past 30 years, China has transformed itself, posting extraordinary rates of growth and increasing the living standards of nearly all its citizens. At the same time, China has become a far less equal nation, with vast differences emerging between those living in rural versus urban areas, inland versus coastal areas, and globally oriented versus more insular areas.

The worsening global recession has heightened concerns that the United States and other economies could enter a sustained period of deflation, as did Japan in the 1990s and the United States during the Great Depression. Indeed, a popular version of the well-known Phillips curve model of inflation predicts that we are on the cusp of a deflationary spiral in which prices will fall at ever-increasing rates over the next several years.

This Economic Letter summarizes several papers presented at the symposium “The Outlook for Future Productivity Growth” hosted November 14, 2008, by the Federal Reserve Bank of San Francisco’s Center for the Study of Innovation and Productivity (CSIP). The papers are listed at the end and most are available online.

This Economic Letter summarizes the papers presented at the 2008 Annual Pacific Basin conference held September 19-20, 2008, at the Federal Reserve Bank of San Francisco under the sponsorship of the Bank’s Center for Pacific Basin Studies. Conference papers are listed at the end and are available online.

There is considerable concern about the duration and severity of the credit crunch caused by the current financial crisis. Some evidence indicates that this could become one of the worst credit crunches in recent history.

During the current recession, the economy has lost about 3.6 million jobs. In January, the nation’s unemployment rate hit 7.6%, and forecasters expect further job losses and higher unemployment rates in the months ahead. In order to boost the economy and stem job losses, Congress has just approved a substantial fiscal stimulus package, and further measures may well be introduced in the future. One measure not included in the package is a temporary federal tax credit for businesses that create jobs in the United States. But such a provision was part of the original plan proposed by the Obama transition team before the president took office and is often cited as a potential addition to the federal government’s arsenal of tax incentives.

Small businesses play a critical role in the U.S. economy, accounting for roughly half of all private employment and more than half of output, according to the U.S. Small Business Administration. Small businesses need financing to operate and grow, and bank lending is an important source of this financing.

The current financial crisis in the United States has its roots in falling real estate values. Indeed, a number of studies have shown a strong link between house price depreciation and defaults on residential mortgages (Doms, Furlong, and Krainer 2007).

Recent declines in house prices and the stock market have led to the most substantial contraction in household wealth since the Great Depression. From the third quarter of 2007 through the third quarter of 2008, household wealth shrank by $6.7 trillion (Federal Reserve Board of Governors 2008).

One of the key features of the financial turmoil of the past year has been the credit crunch. For borrowing of many kinds, terms are tougher and interest rates are higher, reflecting skyrocketing risk premiums.

This Economic Letter introduces the new Tech Pulse Index, a measure that tracks economic activity in the U.S. information technology (IT) sector. The index first appeared under the sponsorship of the Federal Reserve Bank of New York; due to substantial revisions of the econometric model and source data used in the current version, it is not directly comparable to versions released by the New York Fed before August 2008.

This Economic Letter is adapted from a speech delivered by Janet L. Yellen, president and CEO of the Federal Reserve Bank of San Francisco, on January 4, 2009, to the Andrew Brimmer Policy Forum during the IBEFA/ASSA meeting held in San Francisco.

2008

Each year, the President of the San Francisco Fed joins the Federal Reserve Board Governor responsible for liaison with Asia on a “fact-finding” trip to the region. These trips advance the Bank’s broad objectives of serving as a repository of expertise on economic, banking, and financial issues relating to the Pacific Basin and of building ties with policymakers and economic officials there.

Following years of negotiations involving over a dozen European nations, the Maastricht treaty was signed on February 7, 1992, and established the terms and basic timeline for European Economic and Monetary Union (EMU). Despite some bumps along the way, such as the exchange rate mechanism (ERM) crisis in September 1992, the monetary union went ahead largely according to schedule.

This Economic Letter is adapted from a speech delivered by Janet L. Yellen, president and CEO of the Federal Reserve Bank of San Francisco, on October 30, 2008, to the UC Berkeley-UCLA Symposium “The Mortgage Meltdown, the Economy, and Public Policy,” at the University of California, Berkeley.

Nearly seven years have passed since the last recession ended in November 2001. That recession was characterized by an unwinding of excess business investment in the aftermath of a burst U.S. stock market bubble (see Lansing 2003a).

All firms, particularly financial institutions, require access to borrowed funds to carry out their operations, from paying their near-term obligations to making long-term strategic investments. An inability to acquire such funding within a reasonable timeframe could place a firm at risk, as graphically shown by the recent demise of certain investment banks and other financial institutions.

The current downturn has caused the U.S. unemployment rate to rise by nearly 2 percentage points and approach the high of 6.3% reached in the aftermath of the 2001 recession. High unemployment generally is associated with increased slack in labor markets, hence reduced pressure for wage inflation.

As oil prices have climbed over the last several years, the memory of the 1970s and early 1980s has not been far from the minds of the public or of monetary policymakers. In those earlier episodes, rising oil prices were accompanied by double-digit overall inflation in the U.S. and in several other developed economies. Indeed, central bankers say they are determined not to let this experience recur, emphasizing that they intend to maintain their credibility with the public in securing low inflation and achieving stable and well-anchored inflation expectations.

Countries have taken substantial steps to help local firms mitigate their exposure to currency risk by issuing debt denominated in their domestic currencies and by promoting local currency bond markets, as in the Asian Bond Market Initiative. Currency risk arises when a firm’s revenues are in its home currency, while its liabilities are in a foreign currency.

This Economic Letter is adapted from speeches delivered by Janet L. Yellen, president and CEO of the Federal Reserve Bank of San Francisco, on September 4 and 5, 2008, to a group of community leaders in Salt Lake City, Utah, and to the Rotary Club of Los Angeles, respectively.

This Economic Letter summarizes several papers presented at the Federal Reserve Bank of San Francisco’s Applied Microeconomics Summer Conference, held June 25-27, 2008. The papers are listed at the end and are available online.

Extensive scientific evidence suggests that the worldwide climate has been warming in recent decades and is likely to continue doing so (IPCC 2007). The possible contribution of human activity has produced considerable debate about appropriate responses by governments, businesses, and individuals to “mitigate” (limit) the extent of global warming by reducing greenhouse gas emissions, a primary source of which is fossil fuels.

The mandate of the Federal Reserve in carrying out monetary policy is to pursue price stability and maximum employment; while not formally defined for U.S. monetary policy, price stability generally is assumed to imply a “low” and predictable rate of inflation over a period of time. One way to gauge the success of monetary policy in meeting the mandate regarding price stability is to look at expectations of inflation, which, as studies have shown, influence future inflation rates.

Those who have spent time in a kindergarten classroom know that there are remarkable differences in children’s skills. Research has shown that these skill differences are strongly tied to age, with students who enter kindergarten later in life doing better than younger entrants.

Recent surveys have shown that households are expecting higher inflation in the future. These readings, coming at the same time as surging commodity prices, have raised concerns that inflation expectations are no longer well-anchored and that the Fed has lost credibility.

This Economic Letter summarizes the papers presented at a conference on “Monetary Policy and Asset Markets” held at the Federal Reserve Bank of San Francisco on February 22, 2008. The papers are listed at the end and are available online.

This Economic Letter summarizes the presentations at a symposium held at the Federal Reserve Bank of San Francisco on May 9, 2008, sponsored by the Bank’s Center for the Study of Innovation and Productivity (CSIP). Presentations are listed at the end, and three of the four are available online.

In the U.S. economy, two-thirds of production and expenditures are devoted to consumer spending, or personal consumption expenditures (PCE), which include most of retail sales, as well as households’ expenditures on such items as rent, utilities, and much of medical care. Because this is such a large sector of the economy, the forecast accuracy of PCE affects the forecast accuracy of some of the key variables that policymakers focus on, such as unemployment, incomes, inflation, and interest rates.

The magnitude of short-term movements in asset prices remains a challenge to explain within a framework of rational, efficient markets. Numerous empirical studies have shown that stock prices appear to exhibit “excess volatility,” that is, prices move too much to be explained by changes in the underlying fundamentals, such as dividends or cash flows.

In the latter half of 2007, the media were full of stories about recalls of consumer goods produced in China, with the majority related to high concentrations of lead used in the paint for toys. The volumes and the values of the affected goods were large; for example, the value of toy industry recalls totaled almost 20% of the overall monthly import of toys and related products from China.

Long gone are the days when most American workers could rely on their employers to manage their retirement savings. Today, most people handle their retirement portfolios themselves, gaining the right and responsibility to determine their own best strategies.

Small businesses are a vital part of the fabric of the U.S. economy—according to the Small Business Administration, small businesses employ roughly half of the nation’s workers. So the question of how much bank financing small businesses are able to obtain is of real importance.

Though much of the current discussion about global imbalances focuses on the swelling current account deficit in the U.S., the other side of this imbalance itself presents a puzzle. Specifically, the increase in U.S. international liabilities must be matched by an increase in assets elsewhere, and, in the current environment, a prominent “elsewhere” is among emerging Asian economies.

Much of the current trouble in the housing market has been attributed to the fact that house price appreciation—strong for many years—is finally slowing; indeed, in many markets now, house prices are falling. The mere fact that falling house prices are considered newsworthy is interesting in its own right. In other asset markets, such as the stock and bond markets, prices routinely fluctuate up and down every day.

As of the end of the fourth quarter of 2006 the outstanding notional amount of U.S. corporate bonds totaled $8.2 trillion, the third largest asset class after equities and mortgage-backed securities in the U.S. Investors in the corporate bond market range from private individuals to banks and other institutional investors such as mutual funds and life insurance companies.

In 2007, Federal Reserve policymakers and others who pay close attention to the health of the nation’s labor markets were seeing conflicting signals from two important data series on employment that often move largely in tandem. As expected, following fairly robust growth rates in 2006, both series showed reduced growth rates in 2007 as economic activity was slowing.

This Economic Letter summarizes proceedings of a symposium held at the Federal Reserve Bank of San Francisco on October 19, 2007, sponsored by the Bank’s Center for the Study of Innovation and Productivity (CSIP). The symposium brought together academic researchers and private equity practitioners, including representatives of private equity firms, investors in private equity, and lenders.

Each year, the President of the San Francisco Fed joins the Federal Reserve Board Governor responsible for liaison with Asia on a “fact-finding” trip to the region. These trips advance the Bank’s broad objectives of serving as a repository of expertise on economic, banking, and financial issues relating to the Pacific Basin and of building ties with policymakers and economic officials there.

This Economic Letter summarizes the papers presented at a conference on “Recent Trends in Economic Volatility” held at the Federal Reserve Bank of San Francisco on November 2 and 3, 2007. The papers are listed at the end and are available online.

This Economic Letter is adapted from a speech by Janet L. Yellen, president and chief executive officer of the Federal Reserve Bank of San Francisco, to the Chartered Financial Analysts of Hawaii in Honolulu, Hawaii, on February 7, 2008.

This Economic Letter summarizes the papers presented at the 2007 Annual Pacific Basin conference held at the Federal Reserve Bank of San Francisco on June 8-9, 2007, under the sponsorship of the Bank’s Center for Pacific Basin Studies. The papers are listed at the end and are online.

Over the past two decades, the Federal Reserve has made significant strides toward greater transparency in the conduct of monetary policy. Most recently, last November, Federal Open Market Committee (FOMC) participants—that is, the Federal Reserve Presidents and Governors—started to release their projections for output growth, unemployment, and inflation to the public more frequently and with greater detail than before (Rudebusch 2008).

Given the time lag between a monetary policy action and its effect on the economy, the importance of considering economic forecasts in the conduct of policy has long been acknowledged. Still, it is only over the past decade or so that the publication of central bank economic forecasts has been widely recognized as a potentially useful tool for monetary policy communication.

This Economic Letter is adapted from a speech by Janet L. Yellen, president and chief executive officer of the Federal Reserve Bank of San Francisco, to the Seattle Community Development Roundtable and the Seattle Chamber of Commerce Board of Trustees in Seattle, Washington, on December 3, 2007.

Price rigidity is a key mechanism through which monetary policy is thought to affect the economy. When some prices are hard to change, firms may respond to a monetary impetus by changing instead their production and employment levels.

This Economic Letter is adapted from a speech by Mark Spiegel, Vice President and Director of the Center for Pacific Basin Studies, delivered at the Bank of Korea’s 15th annual Central Banking Seminar, “Increasing Capital Flows among Countries and Monetary Policy,” in Seoul, Republic of Korea, September 18-21, 2007.

Growth in the labor force is one of two key determinants of the nation’s maximum sustainable, or potential, rate of economic expansion. For more than five decades, a growing labor force provided a sizeable boost to the potential rate of expansion in the U.S. economy.

Speculative bubbles have occurred throughout history in numerous countries and asset markets. The term “bubble” was coined in England in 1720 following the famous price run-up and crash of shares in the South Sea Company.

Access to external finance, such as bank loans or trade credit, is a key determinant of a firm’s ability to develop, operate, and expand. Economic researchers have studied how various macroeconomic and microeconomic factors influence such access; for example, it has been shown to depend on the macroeconomic environment, since economic downturns tend to limit firms’ ability to borrow and banks’ willingness to lend.

For most people, the idea that individuals compare themselves to others in determining their own utility, that is, their sense of happiness or well-being, rings true. Memories from the school yard, the neighborhood, and the workplace support the notion that we care both about our own accomplishments and how they stack up against those of others.

A major advancement in risk management among large financial institutions has been the development of internal risk models. The models encompass institutions’ procedures and techniques for assessing portfolio risk.

Over the past four decades, overall income inequality has increased in the U.S. One particularly striking feature of the data is that the income gap has widened most between the top and the middle of the distribution, while it has remained relatively stable between the middle and the bottom.

This Economic Letter is adapted from a speech by Janet L. Yellen, president and chief executive officer of the Federal Reserve Bank of San Francisco, to the National Association for Business Economics in San Francisco, California, on September 10, 2007.

As important as productivity growth is to the health of the economy, much remains to be understood about how and why its trend growth rate changes. This Economic Letter discusses some of the points of debate in the research on these issues.

Most people barely think twice anymore when they discover that their toothbrush was made in China, their tee-shirt was made in Honduras, and their car was made in Germany. With an increasing volume of goods and services flowing around the world, it is natural to assume that the marketplace has become “global,” which is to say, much more integrated.

The San Francisco Bay Area has long been a key center of information technology (IT) innovation and production. This Economic Letter explores how IT employment trends have evolved in this area, as well as how they compare to other key IT centers and the nation.

Community banks, by virtue of their size and emphasis on so-called relationship banking, typically have limited geographic scope in their activities. This would seem to imply that their financial performance would be tied closely to the financial condition of their customers and, thus, to the economic conditions in regional banking markets.

From January 2000 through this past June, the 10-year U.S. Treasury bond yield has moved over a wide range, falling from 6.8% in early 2000 to 3.1% in June 2003 and rising back to over 5% more recently. The interest rate on 30-year fixed-rate mortgages has similarly varied from a high of 8.6% in 2000 to a low of 5.2% in June 2003 and back to about 6.75% more recently.

This Economic Letter is adapted from a speech by Janet L. Yellen, president and chief executive officer of the Federal Reserve Bank of San Francisco, delivered via videoconference to the First Annual Conference of the U.C. Berkeley-National University of Singapore Risk Management Institute, on July 5, 2007.

This Economic Letter summarizes the presentations made at a symposium by the same title sponsored by the Center for the Study of Innovation and Productivity and held at the Federal Reserve Bank of San Francisco on May 25, 2007.

According to several measures, the difference in wages between men and women, the so-called “male-female wage gap” (MFWG), has shrunk substantially–by about half–over the past several decades. This phenomenon has been the subject of much research, speculation, and contention.

While credit unions have been able to convert their charters more easily since the late 1990s, two conversions of very large credit unions–over $1 billion in assets each–in 2006 have put the issue on the front burner for the industry.

This Economic Letter outlines some costs and benefits to their member-owners of credit unions’ converting to stock thrifts and describes one way to reform the process in order to spread the benefits of conversion more broadly to credit union members.

The recent sharp increase in subprime mortgage delinquencies has captured the public spotlight and led analysts to search for the factors that are likely to have contributed to the problem. These factors commonly include the lack of income documentation, high loan-to-income ratios, the lowering of credit standards, and the resets on adjustable-rate loans, to name but a few.

In recent years, the U.S. economy has expanded at a healthy pace, employment has grown substantially, and the unemployment rate has dropped to very low levels. Despite these favorable trends, some recent news stories have emphasized worker anxiety and uncertainty about their job stability and security, reinvigorating a theme that gained substantial prominence in the mid-1990s.

This Economic Letter summarizes the papers presented at a conference on “Monetary Policy, Transparency, and Credibility” held at the Federal Reserve Bank of San Francisco on March 23 and 24, 2007. The papers are listed at the end and are available online.

The U.S. bank supervisory agencies recently issued for public comment revised guidance regarding the implementation of the proposed Basel II-related, risk-based capital requirements. Among the revisions is an important update to guidance regarding operational risk management.

The European Central Bank (ECB) and the Federal Reserve share a similar goal, price stability, and their strategies to pursue their goals are similar–with one notable difference. When considering long-term risks to price stability, the ECB places an explicit emphasis on the link between prices and measures of the money supply (also known as monetary aggregates); the Federal Reserve System, in contrast, does not specifically emphasize monetary aggregates.

Strong productivity growth is essential for improving living standards and can have an important impact on economic policy, yet economists are far from being experts at predicting when the trend of productivity growth might shift. In the 1960s, productivity growth boomed, growing at an average annual rate of 2-1/2%. It weakened in the early 1970s, and for the next two decades or so averaged an annual growth rate of only about 1-1/4%.

On March 14, the Bureau of Economic Analysis reported that the U.S. current account deficit for 2006 increased from the previous year to over 6% of GDP. This deficit reflects the difference between U.S. income and expenditures, and the additional indebtedness that the country needs to take on to cover this difference.

While China’s economic reforms have engendered much success since they were undertaken in the late 1970s—real GDP growth has averaged roughly 10% per year over the period—the development of its financial system arguably lags behind. Very high investment (over 40% of GDP) has fueled much of the recent growth, but, as some claim, it also has generated excess capacity in the economy, a sign of inefficient allocation of capital.

Each year, the President of the San Francisco Fed joins the Federal Reserve Board Governor responsible for liaison with Asia on a “fact-finding” trip to the region. These trips advance the Bank’s broad objectives of serving as a repository of expertise on economic, banking, and financial issues relating to the Pacific Basin and of building ties with policymakers and economic officials there.

This Economic Letter summarizes the papers presented at the conference “Financial Innovations and the Real Economy” held at the Federal Reserve Bank of San Francisco by the Bank’s Center for the Study of Innovation and Productivity on November 16–17, 2006.

This Economic Letter summarizes the papers presented at the annual Pacific Basin Conference held at the Federal Reserve Bank of San Francisco on June 16-17, 2006, under the sponsorship of the Bank’s Center for Pacific Basin Studies. The papers are listed at the end and are available online.

In the latest episode of monetary tightening in the United States, the Federal Open Market Committee (FOMC), which sets U.S. monetary policy, raised the target level of its key policy interest rate, the federal funds rate, from 1% in June 2004 to 5-1/4% in June 2006. This gradual increase was accomplished via a sequence of 17 consecutive 25-basis-point increases at successive FOMC meetings.

Over the past several years, movements in asset prices have substantially raised household wealth. For the U.S. and many other industrialized countries, the most recent boost has come more from the appreciation of house prices than financial assets.

Commercial real estate (CRE), such as office towers, shopping centers, and apartment buildings, makes up approximately one-third of the total value of U.S. real estate. Not surprisingly, CRE-related loans account for a significant portion of total bank lending—about 22% as of 2005.

2006

As 2006 draws to a close, one economic development that stands out over the year is the slowdown in the housing sector. In particular, the slowdown raises concerns about the perceived shift households have made toward “alternative” mortgage products, which may leave them more exposed to negative effects from higher interest rates and falling house prices.

The December 12, 2006, statement of the Federal Open Market Committee (FOMC) said, “Readings on core inflation have been elevated, and the high level of resource utilization has the potential to sustain inflation pressures.” The link between “inflation pressures” and the “level of resource utilization” is formalized by the Phillips curve, which says that short-term movements in inflation and unemployment (a measure of labor resource utilization) tend to go in opposite directions.

Historically, small businesses have tended to turn to local lenders for credit. In recent years, however, technological advances in processing information and assessing credit risk have raised the potential for loosening the geographic ties between small business borrowers and lenders. This Economic Letter discusses factors affecting the geographic scope of markets for small business credit and uses data available for the San Francisco Bay Area to examine the extent to which small businesses rely on local lenders, how this reliance has changed over time, and the implications of any changes for the Federal Reserve’s bank merger policy.

The share of corporate profits in the U.S. collected by state governments via the corporate income tax has fallen sharply in the past quarter century. Some commentators have even referred to this as the “disappearance” of the state corporate income tax (SCIT).

This Economic Letter is adapted from the 2006-2007 Economics of Governance Lecture delivered by Janet L. Yellen, president and CEO of the Federal Reserve Bank of San Francisco, at the Center for the Study of Democracy, University of California, Irvine, on November 6, 2006.

The sharp slowdown in housing and the inverted yield curve have led to concerns that the odds of a recession have risen. For instance, Dow Jones Newswire reported on November 2 that one model based on the yield curve put the probability of a recession over the next four quarters at more than 50%.

The U.S. dollar has seen some remarkable swings against major currencies recently. For example, over most of 2005, it gained nearly 18% against the yen and 13% against the euro, while between March and May 2006, it depreciated sharply against these currencies, losing almost 10% of its value.

After decades of relative stability, the rate of U.S. homeownership began to surge in the mid-1990s, rising from 64% in 1994 to a peak of 69% in 2004, near which it has hovered ever since; this translates into 12 million more homeowners over the period (Figure 1).

The U.S. current account has been in deficit since the beginning of the 1980s, except for a brief period in 1991, and has grown to 6.6% of gross domestic product (GDP) in the second quarter of 2006. The growing deficit has clearly caught the attention of policymakers and analysts.

On March 19, 2001, the Bank of Japan (BOJ) embarked on an unprecedented monetary policy experiment, commonly referred to as “quantitative easing,” in an attempt to stimulate the nation’s stagnant economy. Under this policy, the BOJ increased its target for “current account balances” of commercial banks at the BOJ far in excess of their required reserve levels.

Inflation expectations and core inflation in the United States have been remarkably stable during the past 10 years, a dramatic break from the pattern seen in the prior two decades, as seen in Figure 1. Indeed, long-run inflation expectations, as measured by the median response of the Survey of Professional Forecasters have barely budged since 1998.

The U.S. banking industry has enjoyed record profitability and very low failure rates in recent years. This scenario is a welcome contrast to the 1980s, when turbulent economic conditions, the crisis in the savings and loan industry, and a highly volatile interest rate environment put the banking industry under severe stress.

As discussed in a recent (Jones 2005), the share of health-care spending in GDP has been rising rapidly in the United States and other advanced industrial countries since at least 1960. For example, data from the U.S. Centers for Medicare and Medicaid Services (CMS) indicate double-digit annual increases in premiums for private health plans during the years 2001-2003, which significantly increased the overall share of business and household expenditures devoted to medical services.

With the price of oil in world energy markets having nearly quadrupled over the last four years, it is little surprise that U.S. import prices have soared. One concern about these higher import prices relates to their implications for the U.S. trade balance, which turned to a deficit in 1992 and has been deteriorating ever since.

Since February of 2002, the dollar has lost 27% of its value relative to other major currencies. Over the same period, consumer prices (excluding food and energy goods) have increased by a much smaller amount—8.9%.

A great deal of recent research has pointed out the benefits of adopting inflation targets, emphasizing, in particular, their role in helping to stabilize inflation expectations. As we discuss below, these arguments suggest that inflation expectations in countries that target inflation should react differently to the recent oil price shocks than expectations in countries that do not target inflation.

Economic forecasters often look to the performance of futures markets to help predict such economic developments as movements in the price of oil and other commodities. In addition, relatively new financial market instruments, like TIPS (Treasury Inflation Protected Securities) help policymakers get a handle on the public’s inflation expectations.

Since the October 2005 nomination of Ben Bernanke to become Chairman of the Federal Reserve Board, there has been increasing speculation in the financial press that the Federal Open Market Committee (FOMC) might soon adopt an explicit numerical objective for inflation. However, skeptics of inflation targeting have maintained that this would constrain the FOMC and might provide little benefit in return—after all, it has been argued, haven’t inflation expectations in the U.S. been well anchored since the early to mid-1990s?

By various measures, larger credit unions have recently had stronger financial performance than smaller credit unions, indicating that these institutions face large and pervasive economies of scale (Wilcox 2005a). This Economic Letter uses data from the 1980-2004 period to show that this performance difference is a long-running state of affairs.

With households’ property debt surging, the use of adjustable-rate mortgages increasing, and interest rates rising, some observers have raised concerns about households’ ability to service that debt. To gain a better idea of the distribution of property debt burdens and how it has changed over time, this Economic Letter presents data from the Survey of Consumer Finances (SCF), which contains information on different types of property debt, debt service, and income.

This year’s conference brought academic researchers and policymakers together to discuss six research papers that focused on labor markets, and how labor market behavior can influence the broader macroeconomy.

Each year, the President of the San Francisco Fed joins the Federal Reserve Board Governor responsible for liaison with Asia on a “fact-finding” trip to the region. These trips advance the Bank’s broad objectives of serving as a repository of expertise on economic, banking, and financial issues relating to the Pacific Basin and of building ties with policymakers and economic officials there.

Much attention recently has been given to the possibility of a slowdown in the U.S. residential real estate market. While real residential investment has continued to grow and existing house prices have held up through the first quarter of 2006, analysts have pointed to other signs of slowing.

For several years, the U.S. has had a large and growing deficit in its current account, the broadest measure of the country’s trade with the rest of the world. While in 1991 the current account was roughly in balance, at the end of 2005 it reached a deficit of 7% of GDP.

This Economic Letter is adapted from remarks by Janet L. Yellen, President and CEO of the Federal Reserve Bank of San Francisco, delivered at the conference, “The Euro and the Dollar in a Globalized Economy” at the University of California, Santa Cruz on May 27, 2006.

Central bank balance sheets and capital structure in the context of legal independence, transparency, and flexibility to pursue price stability have increasingly been recognized as important issues in the optimal design of central banks. However, capital structure is more complex than a set of accounting conventions designed to organize central bank operations.

This Economic Letter is adapted from remarks by Janet L. Yellen, President and CEO of the Federal Reserve Bank of San Francisco, delivered to the Bay Area Council 2006 Outlook Conference in San Jose, California, on April 18, 2006.

Conditions in labor markets are largely reflected in the number of jobs employers want to fill (job vacancies) and the number of people seeking jobs (the unemployed). Over the business cycle, for example, job vacancy rates and unemployment rates generally exhibit negative co-movement, with high vacancies and low unemployment when the economy is growing and vice versa when the economy is contracting.

Just a few years ago, Wall Street was rocked by scandals about conflicts of interest involving stock analysts’ reports. In response, the U.S. Securities and Exchange Commission (SEC) undertook investigations and filed a number of complaints against some major securities firms and analysts.

The Federal Reserve System is an important participant in the nation’s payments system, which is the infrastructure used for transmitting and settling payments between individuals, firms, and government entities. For example, as reported in the Federal Reserve System’s 2004 annual report, the twelve Federal Reserve Banks processed about 16 billion checks, or about 45%, of the 37 billion checks written in 2003.

This Economic Letter is adapted from remarks by Janet L. Yellen, President and CEO of the Federal Reserve Bank of San Francisco, delivered to the Annual Washington Policy Conference sponsored by the National Association for Business Economics (NABE) in Washington, D.C., on March 13, 2006.

This Economic Letter summarizes the papers presented at the conference on “External Imbalances and Adjustment in the Pacific Basin” held at the Federal Reserve Bank of San Francisco on September 22-23, 2005, under the sponsorship of the Bank’s Center for Pacific Basin Studies.

Financial system redesign has become high political drama in Japan. In August, 2005, Prime Minister Koizumi’s plan to privatize Japan’s huge postal savings and life insurance system (PSS) was defeated in the Lower House of the Diet.

The study of productivity growth is among the most important pursuits of economic science. Assessments of it influence macroeconomic policy and in the long run productivity growth drives improvements in the standard of living, the mix of goods and services available, as well as the mix of jobs in an economy.

This Economic Letter is adapted from remarks by Janet L. Yellen, President and CEO of the Federal Reserve Bank of San Francisco, delivered to the Los Angeles Chapter of the National Association of Business Economists in Los Angeles on January 19, 2006.

2005

The price of oil has risen by about 60% since mid-2004 and by more than 40% since the beginning of 2005. Though the U.S. economy has apparently absorbed this supply shock well so far, the path of future oil prices remains a concern for monetary policymakers.

For the last fifteen years or so, information technology (IT) has become an ever more important part of the U.S. economy. Looking back over the period, there can be little doubt that the growing use of IT contributed significantly to the economy’s performance, especially in the latter half of the 1990s, when output grew rapidly, unemployment declined to 25-year lows, productivity surged, and the inflation rate actually fell.

The automated teller machine (ATM) has become a part of everyday life. According to Dove Consulting (2004), there are approximately 371,000 ATMs in the United States that process 30 million transactions per day.

A familiar old saw about the conduct of monetary policy is that it’s like trying to drive a car while looking only in the rearview mirror. The idea is that policymakers are trying to steer a course that will keep the economy close to full employment with low, stable inflation, while their only knowledge of the road ahead is based on data about the past.

Over the last decade, a variety of financial tools have been developed for transferring credit risk between financial institutions. Credit risk is defined as the risk that the value of a corporate loan (or debt obligation more generally) will decline due to a change in the borrower’s ability to make payments, whether that change is an actual default or a change in the probability of default.

In any meeting of monetary policymakers, uncertainty is likely to play an important role in their deliberations. According to Alan Greenspan (2003), “Uncertainty is not just an important feature of the monetary policy landscape; it is the defining characteristic of that landscape.”

This Economic Letter summarizes the papers presented at the symposium “Revived Bretton Woods System: A New Paradigm for Asian Development?” held at the Federal Reserve Bank of San Francisco on February 4, 2005, under the joint sponsorship of the Bank’s Center for Pacific Basin Studies and the University of California at Berkeley’s Clausen Center for International Economics.

Oil prices have increased substantially over the last several years. When oil price increases of this magnitude occurred during the 1970s, they were associated with severe recessions. Why hasn’t that happened this time around? This Letter explores some answers to that question.

In September 2005, the personal saving rate out of disposable income was negative for the fourth consecutive month. A negative saving rate means that U.S. consumers are spending more than 100% of their monthly after-tax income.

Whether depository institutions can achieve economies of scale, that is, lower their average costs by increasing their sizes, has been a subject of great interest and importance to economists, regulators, and depository institutions themselves. Deregulation has allowed banks, thrifts, and credit unions to increase their size—and, thereby, to reap whatever economies of scale have long been available to larger depositories—by easing restrictions on their abilities to acquire other financial institutions and to operate over broader geographic areas.

Oil prices have risen sharply over the last year, leading to concerns that we could see a repeat of the 1970s, when rising oil prices were accompanied by severe recessions and surging inflation. This Economic Letter examines the historical relationship between oil price shocks and inflation in light of some recent research and goes on to discuss what the recent jump in oil prices might mean for inflation in the future.

On September 20, the Federal Open Market Committee, the nation’s monetary policymaking body, raised its target level of the federal funds rate by 25 basis points, the eleventh straight increase over the last fifteen months. The statement released immediately after the meeting said, “With underlying inflation expected to be contained, the Committee believes that policy accommodation can be removed at a pace that is likely to be measured.

Tax credits for spending on research and development (R&D) were first enacted into federal law in the U.S. in 1981. In the ensuing quarter century, many states have adopted such tax credits, often using the federal tax credit as a model.

The Federal Reserve wants to know what people think—specifically, the Fed wants to know what people think the future path of inflation is. One reason is that people’s expectations about inflation influence their behavior in the marketplace, and that, in turn, has consequences for future inflation.

Over the past twenty years, output growth in the U.S. has become noticeably less volatile. During that time, the economy has experienced two recessions, compared with four in each of the two preceding twenty year periods.

On July 21, 2005, after more than a decade of strictly pegging the renminbi to the U.S. dollar at an exchange rate of 8.28, the People’s Bank of China (PBOC 2005a) announced a revaluation of the currency and a reform of the exchange rate regime. The revaluation puts the renminbi at 8.11 against the dollar, which amounts to an appreciation of 2.1%. Under the reform, the PBOC will incorporate a “reference basket” of currencies when choosing its target for the renminbi.

This Economic Letter is adapted from remarks by Janet L. Yellen, President and CEO of the Federal Reserve Bank of San Francisco, delivered at the Twelfth International Conference, “Incentive Mechanisms for Economic Policymakers,” at the Institute for Monetary and Economic Studies at the Bank of Japan in Tokyo on May 31, 2005.

Over the past few decades, assets in the credit union industry have grown considerably and have grown relative to banking. As with banking, the credit union industry has experienced considerable structural change that, in part, involved failures.

In 1999, eleven European countries adopted the euro as their common currency (Greece followed in 2001). This followed a long period of gradually tying their national currencies together more tightly by limiting exchange rate fluctuations among member countries, culminating in the European Monetary Union (EMU).

In theory at least, an asset price can be separated into a component determined by underlying economic fundamentals and a nonfundamental bubble component that may reflect price speculation or irrational investor euphoria or depression. The expansion of an asset price bubble may lead to a debilitating misallocation of economic resources, and its collapse may cause severe strains on the financial system and destabilize the economy.

World financial markets paid close attention when officials from both South Korea and Japan said that their governments were considering diversifying their holdings of foreign reserves (Dougherty 2005 and Koizumi 2005). Many analysts thought these announcements were partly in response to the past depreciation of the dollar; if true, then it seemed likely that those two governments would sell some of their dollar-denominated assets, putting further downward pressure on the dollar.

Since 2002, the U.S. has seen the emergence of twin deficits—that is, a growing budget deficit along with a growing current account deficit, which reflects increasing U.S. borrowing from abroad. To some analysts, this situation seems very reminiscent of the early 1980s. In the earlier episode, there were significant tax rate cuts that were not matched by spending cuts, and between 1981 and 1986, the U.S. budget deficit went from 2.5% of GDP to about 5% of GDP and the current account went from being roughly in balance to a deficit of 3.3% of GDP.

The national unemployment rate fell slowly during the first half of 2005, reaching 5.0% in June. While this is above the lows reached in 1999-2000, it is noticeably below the rates that largely prevailed during the mid-1970s through the mid-1990s.

Investment in information technology (IT)—that is, business spending on computers, communications equipment, and software—has featured prominently in the ups and downs of U.S. economic growth over the last decade. In the late 1990s, double-digit growth in IT investment contributed significantly to high GDP and productivity growth rates. And in 2001, the sharp contraction in IT investment helped lead the economy into recession.

This year’s conference brought together six research papers that explore issues related to fiscal and monetary policy and their interaction. The papers ranged from a theoretical analysis of the design of fiscal policy in a monetary union to the use of long-term bond rates to estimate monetary policy reaction functions.

Policymakers at both the state and local level have long used tax incentives, in some form or other, to entice firms to locate or stay in their communities. While some economists have raised serious concerns about whether such incentives lead to socially wasteful “tax competition,” a federal appeals court decision in September 2004 has raised serious doubts about whether some are even constitutional.

Debates about health care have been a central feature of U.S. public policy discussions for at least the last 20 years. One trigger of these debates is the statistical evidence on the rising cost of health care.

There is a well-worn story that illustrates how economists view financial markets (and, perhaps, the rest of the world). An economist and a non-economist are walking down the street. The non-economist spots a $20 bill on the sidewalk and starts to reach for it.

There is a well-worn story that illustrates how economists view financial markets (and, perhaps, the rest of the world). An economist and a non-economist are walking down the street. The non-economist spots a $20 bill on the sidewalk and starts to reach for it.

In most countries’ experience, the course of financial liberalization—much like the course of true love in Shakespeare—”never did run smooth.” The process of reforming an economy from one where the government takes the lead in allocating financial and real resources to one where market forces determine economic outcomes can involve choices and consequences that are painful and costly.

At the beginning of the 1990s, policy doctors were almost unanimous in advocating a strong dose of capital and financial market liberation for developing countries as a way to improve their prospects for economic growth. The expectation was that such liberalization would make foreign saving available to local entrepreneurs, who would invest it in building the businesses, homes, and other infrastructure of their countries’ economies.

The performance of productivity in the U.S. economy has delivered some big surprises over the last several years. One surprise was in the latter half of the 1990s, when productivity growth surged to average an annual rate of over 3%, more than twice as fast as the rate in the previous two decades.

Several recent developments have raised concerns about a productivity slowdown in the U.S. that could slow economic growth and boost inflation. For example, after soaring at the astounding rate of nearly 4-1/2% in 2002, 2003, and the first half of 2004, nonfarm labor productivity growth slowed to around 1-3/4% in the third quarter of last year and to only 3/4% in the fourth quarter.

The last decade has witnessed a series of major macroeconomic crises in emerging market economies. Typically these crises have been characterized by the sudden stop of capital inflows, the collapse of fixed exchange rate regimes, falls in asset prices, and sharp declines in output.

The job vacancy rate, which represents employers’ unmet labor demand, is an important indicator of the short-term outlook for hiring and job creation. Because there is no continuous aggregate vacancy series in the United States, analysts and observers interested in labor demand and hiring activity have relied on the Conference Board’s “Help-Wanted Advertising Index” to measure changes in job vacancies over time.

Many economists argue that a flexible exchange rate regime is preferable to a fixed exchange rate regime because it helps to insulate the domestic economy from adverse external shocks. For example, when export demand declines, a depreciation makes domestic goods more competitive abroad, stimulates an offsetting expansion in demand, and dampens the contraction in domestic economic activity.

2004

In the years following the Asian financial crisis of 1997-1998, the governments of South Korea and Thailand each have sought to generate economic recovery by expanding domestic credit. The rapid credit expansion in both countries has created concerns about the extent to which their economies can channel these funds efficiently and sustain economic growth.

The phenomenal performance of labor productivity that has marked the U.S. since the mid-1990s has not only fostered economic growth and real gains in wages, but it also has kept economists busy trying to understand its underlying causes. Many studies focus on the broad economy and find that information technology (IT) has played a major role.

Although the swings in economic measures during the last recession and recovery were fairly modest, swings in financial markets were quite large. Once financial markets found their footing, after steep losses in 2000-2002, prices on virtually all traded financial claims rose as the economic outlook improved.

Twenty-five years ago, on October 6, 1979, the Federal Reserve adopted new policy procedures that led to skyrocketing interest rates and two back-to-back recessions but that also broke the back of inflation and ushered in the environment of low inflation and general economic stability the United States has enjoyed for nearly two decades. The dramatic policy actions by the Federal Reserve in 1979 represented an important break with the past, both in the way monetary policy was conducted and in the importance placed on controlling inflation.

In the financial services industry, outsourcing has been in use for quite some time. For example, since the 1970s, financial institutions have used outside firms for such clerical activities as printing customer financial statements and storing records.

Based on the latest data and forecasts from Japan, it would be premature to declare the end of that country’s deflationary period. The Bank of Japan (BOJ) forecasts that consumer prices will continue to fall through the 2004 fiscal year, which ends in March 2005, albeit only at a 0.1% to 0.2% annual pace.

As the U.S. economy becomes more “knowledge-based,” the decisions that policymakers and firms make about spending on research and development (R&D) take on increasing significance. In making those decisions, an important dynamic of R&D to consider is that most innovations borrow heavily from prior or related work; this implies that enhancing the potential for such “spillovers” from one researcher’s innovative efforts to another’s could make R&D more productive.

This Economic Letter is adapted from remarks delivered to the International Financial Institutions Association of California and the National Association of Chinese American Bankers in Santa Monica, California, on October 15, 2004.

A recent front-page article in the Wall Street Journal documented an increasing tendency among economists to move away from theories of efficient stock market valuation in favor of “behavioral” models that emphasize the role of irrational investors (see Hilsenrath 2004). The long-run rate of return on stocks is ultimately determined by the stream of corporate earnings distributions (cash flows) that accrue to shareholders.

Policymakers and forecasters pay close attention to a lot of indicators that help them understand the economy’s current condition and the conditions that are likely to prevail in the future. One of the key indicators is not a so-called “hard” statistic, like “Real Gross Private Domestic Investment.”

In recent months, some Federal Reserve officials have discussed the organization’s efforts at communicating to make the foundations of their decisionmaking more transparent to the public. Janet Yellen, president of the Federal Reserve Bank of San Francisco, said, “The reason for the focus on communication is that economic developments are affected by longer-term interest rates, equity values, the exchange rate, and other asset values—and these factors depend not only on the current [federal] funds rate, but, more importantly, on the expected future path of the funds rate” (Yellen 2004).

The performance of the residential housing market over the last ten years has been remarkable. According to the Office of Federal Housing Enterprise Oversight (OFHEO), house prices have appreciated at an annual rate of 5.4% on average (68.9% over the whole time period).

Over the past 20 years, financial institutions have made significant efforts to establish and improve their procedures for interest rate risk management, including using economic models of interest rates and related models of credit risk (Lopez 2001a, b). At the same time, bank supervisors worldwide, including the Federal Reserve, have been expanding their knowledge and oversight of interest rate risk management techniques.

The U.S. current account deficit has been growing for several years, as the country has been importing increasingly more than it has been exporting. In 1992, the current account deficit was 0.8% of GDP, and by the end of 2003, it had soared to an unprecedented 4.8% of GDP.

In just about ten years or so, the commercial use of the internet has metamorphosed from a researcher’s tool to an everyday business necessity. Indeed, a large fraction of the boom in business investment in information technology (IT) was related to business applications and infrastructure using internet-related technology.

Since the end of the 2001 recession, the U.S. economy has performed pretty well in terms of output growth, averaging about 3-1/4 percent a year. But how well has the economy performed in terms of creating jobs?

Many countries go to great lengths to manage their exchange rates. Probably the most prominent recent example is the European Monetary Union, where all the members abandoned their national currencies and adopted the euro.

Beginning in early 2002, the dollar tumbled against major currencies like the euro, the British pound, and the Japanese yen; though it has risen somewhat in recent months, it is still well below that peak. One of the key questions this has raised for U.S. monetary policymakers is: How much of the decline in the dollar passed through to import prices and to overall consumer prices?

Most economists would argue that monetary integration leads to financial integration; in other words, when a set of countries has a common currency, as in the European Monetary Union (EMU), for example, those countries also would tend to have more extensive international financial activity. Two main reasons are generally cited. First, monetary integration reduces “currency risk,” which is the risk that the value of debt obligations would change due to fluctuations in currency values.

Since the introduction of the IBM PC in 1981, desktop computers have become a standard fixture in most workplaces. Through their ubiquity and impact on how work is done, personal computers (PCs) arguably have transformed the workplace.

Ask any economist and he or she will tell you that faster productivity growth leads to higher real wages and improved living standards. So, from those perspectives, the recent evidence of strong productivity growth in the U.S. is good news.

Central banks use macroeconomic models to help frame the issues that they face, to mold their ideas, and to guide them in their decisionmaking. While a wide range of models are available, economists are increasingly examining monetary policy issues and the design of optimal monetary policies in the context of “New Keynesian” macroeconomic models.

When Congress enacted the Community Reinvestment Act (CRA) in 1977, its main goal was to address concerns that some banking institutions were not fully meeting the credit needs of qualified potential borrowers, particularly those in low- and moderate-income (LMI) and minority neighborhoods of inner cities. Since then, debate has continued over the need for, and the effectiveness of, the CRA.

Until this year, Citigroup was the only $1 trillion banking organization in the U.S. Now, there are two more—Bank of America has merged with FleetBoston, and J.P. Morgan Chase is about to complete its merger with Bank One. These megamergers are notable not only for their size but also for the geographic scope that the new institutions will serve.

Central banks and other policy institutions have a long history of using macroeconomic models to help prepare forecasts and to quantify the economic consequences of various policies. Likewise, private sector firms have long depended on models to summarize these complex interactions succinctly and to evaluate the likelihood of specific macroeconomic outcomes; this is especially true for financial institutions, where such models can help with capital investment and asset allocation decisions.

This Economic Letter summarizes the papers presented at a conference on “Interest Rates and Monetary Policy” held at the Federal Reserve Bank of San Francisco on March 19 and 20, 2004, under the joint sponsorship of the Federal Reserve Bank of San Francisco and the Stanford Institute for Economic Policy Research.

As a monetary policymaker, my main concern is the health of the U.S. economy. Although the economy turned in a pretty sluggish performance for a long while after the 2001 recession, it has shown some real strength over the last few quarters in terms of output growth and productivity.

International patent protection was a key issue at the multilateral trade talkssponsored by the World Trade Organization in Cancun in September 2003. Indeed,since the organization was founded almost ten years ago, the international protectionof intellectual property rights (IPR) has been a bone of contention between developingand industrialized countries.

Since the second half of the 1990s, the growth rate of labor productivity has been faster than at any time since the 1960s, especially in the manufacturing sector. This turnaround in labor productivity had led many to wonder whether there is something “new” going on in the U.S. economy, and, if so, whether it is sustainable.

There are enormous differences among countries in terms of what kinds of capital equipment they use. These differences are reflected in patterns of imports for the most part, since, except for a few highly advanced, equipment-producing countries, most countries import the vast majority of their equipment.

Since the double-digit inflation of the 1970s, the Federal Reserve has consistently pursued the goal of price stability in the United States. And, since the second half of 2002, the year-to-year increase in the core Consumer Price Index (that is, excluding the relatively volatile food and energy components) has been below 2%, which, according to Fed Governor Bernanke, is probably the de facto equivalent of price stability (Bernanke 2003).

This Economic Letter summarizes papers presented at the conference “Technology, Productivity, and Public Policy” held at the Federal Reserve Bank of San Francisco on November 7-8, 2003. The conference was the inaugural event of the new Center for the Study of Innovation and Productivity (CSIP), which is organized within the Economic Research Department of the Bank.

Ever since Mexico’s “Tequila crisis” in 1994-1995, policymakers have debated how best to reduce the cost of protracted sovereign debt restructuring when emerging markets are in financial crisis. Two dominant approaches have emerged. One promotes changes in the bond contracts international lenders offer; in particular, it encourages the use of collective action clauses (CACs) rather than unanimous action clauses (UACs).

In a speech last month to the annual meeting of the American Economic Association, Fed Chairman Alan Greenspan said, “The Federal Reserve’s experiences over the past two decades make it clear that uncertainty is not just a pervasive feature of the monetary policy landscape; it is the defining characteristic of that landscape.” And he gave some examples of how the Fed made decisions about policy in the face of such uncertainty.

The Fed’s job of stabilizing output in the short run and promoting price stability in the long run involves several steps. First, the Fed tries to estimate how the economy is doing now and how it’s likely to do in the near term—say, over the next couple of years or so.

The point of implementing policy through raising or lowering interest rates is to affect people’s and firms’ demand for goods and services. This section discusses how policy actions affect real interest rates, which in turn affect demand and ultimately output, employment, and inflation.

U.S. monetary policy affects all kinds of economic and financial decisions people make in this country—whether to get a loan to buy a new house or car or to start up a company, whether to expand a business by investing in a new plant or equipment, and whether to put savings in a bank, in bonds, or in the stock market, for example. Furthermore, because the U.S. is the largest economy in the world, its monetary policy also has significant economic and financial effects on other countries.

2003

As more and more people use computers at home, at work, and at school, researchers have found that computer use has important implications for our material well-being. One finding, for example, is that people who use computers in the workplace tend to earn higher wages than those who do not, and available evidence suggests that this reflects, at least in part, the direct impact of skills that are associated with or acquired through computer use.

During the 2001 recession and the recovery, bank performance has been remarkably strong. To be sure, banks tightened their lending standards as the economy softened, lessening their exposures to problem areas such as the technology and telecommunications sectors.

Pacific Basin Notes. This series appears on an occasional basis. It is prepared under the auspices of the Center for Pacific Basin Monetary and Economic Studies within the FRBSF’s Economic Research Department.

Bank supervisors monitor bank holding companies (BHCs) in order to enforce regulations and gauge their soundness so as to guard against systemic risk in the financial system. This monitoring is chiefly conducted using supervisory resources, such as bank examinations and quarterly filings of balance sheet information.

The late 1990s witnessed the emergence of the greatest speculative bubble in financial market history. Investors bid up stock prices to unprecedented valuation levels as they extrapolated a temporary surge in corporate earnings growth far into the future.

After being the quintessential darling of the nation’s economy, the San Francisco Bay Area has been battered by the information technology (IT) downturn; nearly one in ten jobs in the Bay Area has disappeared since the peak of late 2000, and half of those were in the IT sector. This Economic Letter explores the sources of the boom and bust in the Bay Area and puts the region’s recent contraction in the context of the U.S. and other regional IT centers.

A key question for monetary policymakers, as well as participants in financial markets, is: “Where are interest rates headed?” In the long run, economists assume that nominal interest rates will tend toward some equilibrium, or “natural,” real rate of interest plus an adjustment for expected long-run inflation.

As the banking industry has consolidated in recent years, the number of banking organizations in the U.S. and in the Twelfth Federal Reserve District has declined dramatically. This consolidation trend raises public policy issues because of its implications for concentration and therefore competition in local banking markets.

The United States arguably is the world’s foremost producer of information technology (IT) products, and for many of these products, the U.S. defines the “leading edge,” or most advanced available technology. Within the U.S., the Twelfth District in particular specializes in IT production. However, amidst the current prolonged slowdown in worldwide IT spending, signs are emerging of a potential erosion of the U.S. competitive advantage.

Rising inequality in individual earnings has been an important feature of the economic landscape in the United States in recent decades. The increased dispersion in yearly earnings has caused some to worry that a more permanent widening of the distribution has occurred.

Last year, the Congressional Budget Office (CBO) released a remarkable report entitled A 125-Year Picture of the Federal Government’s Share of the Economy, 1950 to 2075. This report projects the future of government spending as a share of GDP assuming current policies remain in place, and the projections put forward are stunning: while the share has averaged about 19% since 1950, it is projected to rise drastically in coming decades, more than doubling to 39.7% by 2075.

The question in the title arises from looking at the ratio of patents issued to dollars spent on research and development (R&D). Patents often are thought of as the fruition of R&D spending and as measures of technological progress.

In the last two years, a large number of defined benefit pension plans swung from record overfunding to record underfunding, exposing many workers and retirees to pension risk. The Pension Benefit Guarantee Corporation (PBGC), established by Congress in 1974, mitigates the pension risk to some extent by providing pension insurance.

Paying attention to consumer prices is a key aspect of central banks’ efforts to maintain low and stable inflation. However, measuring consumer prices is not a straightforward or unambiguous procedure.

Fiscal 2004 started on July 1 this year, and it brought little solace to many lawmakers struggling to bring state and local spending back in line with revenues. On the heels of a difficult fiscal 2002 and a worse fiscal 2003, state budget leaders were forced to augment programs of temporary fixes—including deferrals, fund shifts, tapping reserves, and borrowing—with more permanent adjustments, such as slower spending growth and increased taxes and fees.

International efforts are underway to improve the regulation and supervision of banking institutions to reflect advances in financial risk management techniques. In April 2003, the Basel Committee on Banking Supervision (BCBS 2003a), headquartered at the Bank for International Settlements in Switzerland, released for public comment the new Basel Capital Accord, which will replace the 1988 Capital Accord.

Bank lending to businesses tends to be procyclical, contracting with an economic slowdown and rising with an expansion. However, throughout both the recent recovery from recession and the recovery after the early 1990s recession, the volume of commercial and industrial (C&I) loans actually continued to contract.

Many governments have intervened in foreign exchange markets to try to dampen volatility and to slow or reverse currency movements. Their concern is that excessive short-term volatility and longer-term swings in exchange rates that “overshoot” values justified by fundamental conditions may hurt their economies, particularly sectors heavily involved in international trade.

The bursting of the stock market bubble has left many private defined benefit pension plans underfunded, raising some concerns about the effects on cash flows and, for a few firms, on financial soundness (see, for example, Kwan 2003). However, even as the asset value of corporate pension funds has eroded, firms sponsoring defined benefit plans have continued to report unusually low pension costs, because pension earnings have not fallen as much under the accounting rules for pension funds.

Policymakers and economists generally agree that financial development—that is, well-functioning financial institutions and markets, such as commercial and investment banks, and bond and stock exchanges—contribute to economic growth. More debatable, however, have been issues about how financial development promotes growth. These issues would have an impact on choosing the design for financial policies and regulations.

The long bear market in stocks has led to a nearly $1 trillion shrinkage in the value of private pension fund assets: at the peak in 1999, these assets were worth $4.63 trillion; in 2002, they were worth $3.69 trillion. In the case of “defined contribution” plans, the burden of these losses fell on the beneficiaries rather than on the sponsoring firms.

One common misperception about monetary policy is that the Federal Reserve controls all interest rates. In fact, the Fed controls only a very short-term rate, the federal funds rate; this is the rate banks charge each other for overnight loans of reserves.

Economists generally agree on the importance of low and stable inflation as a primary goal of monetary policy, as well as on the key role of inflation and forecasts of future inflation in providing critical signals to which the Fed needs to react. Economists also agree that the measure of real activity relevant for monetary policy is the gap between the level of actual output and an underlying trend level of output.

Among the many challenges the new Iraqi government will face is the choice of a monetary regime that will promote price stability, an essential element in any well-functioning market economy. In forming its new government, Iraq has a rare opportunity to choose the monetary regime that will best suit its unique characteristics.

This Economic Letter summarizes papers presented at the conference “Finance and Macroeconomics” held at the Federal Reserve Bank of San Francisco on February 28 and March 1, 2003, under the joint sponsorship of the Bank and the Stanford Institute for Economic Policy Research.

Since the 1997-1998 Asian financial crises, monetary authorities in emerging markets in East Asia have more than doubled their stockpiles of foreign exchange reserves; by the end of May 2002, they held $845 billion, or 38% of the world total. Of these countries, China, Taiwan, Hong Kong, South Korea, and Singapore rank just behind Japan as the world’s biggest holders of foreign exchange reserves–together those five countries hold reserves totaling nearly $700 billion.

Over the past 20 years inflation in the U.S. economy has been relatively low, averaging about 2.5%; moreover, it has been relatively stable, with a standard deviation of just 1.0%. These statistics may give the impression that inflation has been tamed, or even beaten into submission.

As the bull market of the 1990s has turned into the bear market of the (early) 2000s, households have sharply reversed their more than decade-long trend of increasing their share of assets held in stocks. On balance, households have reallocated their assets away from stocks and toward tangible real assets, such as housing and other durable goods, as well as toward safe liquid financial assets, including cash, bank deposits, and money market mutual funds.

This Economic Letter summarizes the papers presented at the conference “Technological Change,” held at the Federal Reserve Bank of San Francisco on November 14-15, 2002, under the joint sponsorship of the Bank and the Stanford Institute for Economic Policy Research.

This Economic Letter is adapted from remarks by Robert T. Parry, President and CEO of the Federal Reserve Bank of San Francisco, delivered to the Stanford Institute for Economic Policy Research Associates on the campus of Stanford University on March 4, 2003.

California’s labor market has not yet shown much sign of recovery from the recession that began in 2001. As in the rest of the nation, employment has been flat to down, the unemployment rate has remained at elevated levels, and the jobless are facing increasingly lengthy spells of unemployment.

The surge in U.S. productivity growth that began in the mid-1990s has generated considerable debate among economists. While most agree that the boom in information technology (IT) investment greatly contributed to this surge, many argue whether this contribution is mostly due to productivity gains in the manufacture of IT goods or whether the productivity gains “flowed downstream” from the IT manufacturers to the users of IT goods in other industries.

Over the past several years, there has been a steady march toward financial integration across product lines among larger financial firms. The trend is in part due to the increasing globalization of financial markets, the development of new financial instruments, and advances in information technology.

Since the mid-1980s, virtually all states in the nation have seen nonfarm employment growth rates become much more stable than they were in the 1960s, 1970s, and early 1980s. However, the volatility of employment growth has declined by different amounts in different regions.

2002

This Economic Letter summarizes the papers presented at the conference “Financial Issues in the Pacific Basin Region” held at the Federal Reserve Bank of San Francisco on September 26-27, 2002, under the joint sponsorship of the Bank’s Center for Pacific Basin Monetary and Economic Studies and the Journal of the Japanese and International Economies.

In recent years, policymakers and bank regulators have been warming up to the idea of leveraging market forces to enhance banking supervision. This is partly motivated by the growing complexity of large banking organizations and by concerns about limiting the cost of bank supervision as well as avoiding unduly extending the bank safety net (see Kwan 2002).

A key issue on the agenda for bank regulators is how to leverage market discipline to supplement their supervisory efforts. For example, in the recently proposed revision of the Basel Capital Accord, market discipline is one of the three pillars, along with capital regulation and supervision, of the structure for safeguarding the banking system.

The recession that began in early 2001 probably has ended, as national output grew moderately during the first three quarters of 2002. Unemployment, however, remains a problem. Between late 2000 and early 2002, the national unemployment rate increased by about 2 percentage points, from 3.9% to about 6%; this represents about 2.8 million additional individuals looking for work.

U.S. productivity growth surged in the latter half of the 1990s after nearly two decades of lackluster gains. Several states in the West were among the leaders in this productivity growth surge, posting average annual increases well above the rest of the U.S.

Labor productivity, that is, real output per worker (or per worker hour), is a primary determinant of our long-run standard of living. More output per worker translates into higher profits, higher wages, or lower prices—or a combination of the three.

In recent months, it has not been unusual to see the value of major stock indexes, such as the S&P 500, change by as much as 3% in a single day. Unfortunately for many investors, the general direction of those changes has been downward.

Since December 2001, Argentina has suspended payments on its external debt, restricted bank deposit withdrawals, and abandoned a currency board arrangement that had pegged the peso to the U.S. dollar since 1991. Argentina faces inflation of over 70% this year and an economic contraction that rivals the U.S.’s Great Depression.

The Federal Reserve’s monetary policy goals are the maintenance of low inflation and sustainable output growth. Under current operating procedures, the Fed chooses a target for a short-term interest rate—specifically, the overnight federal funds rate, which is an overnight interbank lending rate—that is believed to be consistent with those policy goals.

During the early 1960s, many economists and policymakers believed that monetary policy could exploit a stable trade-off between the level of inflation and the unemployment rate. One version of the hypothesized trade-off, originally described by A.W. Phillips (1958) using U.K. data from 1861-1957, implied that policymakers could permanently lower the unemployment rate by generating higher inflation.

Japan’s Prime Minister Koizumi came to power in April 2001, promising to deal aggressively with the problems that underlay the country’s economic and political instability. Since then, his reform efforts have met increasing resistance, the economy and financial system have yet to improve, and his public support has fallen.

In Europe and other industrialized parts of the world, electronic payment mechanisms have largely replaced checks. But in the U.S., paper checks are still very common, accounting for more than 60% of retail payments.

In recent weeks, a number of signs have appeared suggesting that the recovery of the U.S. economy from the recent recession is on a bumpy path. During the second quarter of 2002, real GDP grew at an anemic annual rate of barely over 1%, well below market expectations.

This Economic Letter is based on a presentation Mark Spiegel prepared for a panel on “Optimal Currency Arrangements for Emerging Market Economies: The Experience of Latin America and Asia,” organized by the Latin American and Asian Economics and Business Association on July 15, 2002, in Tokyo, Japan.

With the high-tech sector still mired in a slump, critical questions include where the industry will head next, and what role Silicon Valley will play in future waves of tech innovation and investment. The Internet and tech investment bust left many failed firms and thousands of unemployed workers in its wake in the Valley.

In the last 25 years, the wage gap in the U.S. between highly skilled and less skilled workers has widened noticeably. For example, in 1975 the gap in average annual earnings between high school graduates and non-graduates was 26%; by 1999, the gap was 52%.

This Economic Letter discusses a topic that at first glance appears to be boring and technical but that in fact turns out to be quite important: the proper interpretation of chain-weighted data. To illustrate, consider this simple question: What is the growth rate of real GDP?

Two major trends affecting the structure of the banking industry since the mid-1980s have been tremendous consolidation and the liberalization of interstate banking. Consolidation has unambiguously increased concentration at the national level.

Health care spending is growing rapidly in the U.S. and, at 14% of GDP, is much larger than such spending in other industrialized countries. The increase in spending reflects not only changing U.S. demographics but also the use of new, and often costly, treatments, as well as institutional factors relating to health insurance and the structure of the health care industry.

Over the 1990s, public and private international borrowers shifted the composition of their external financing—instead of relying primarily on loans from a syndicate of a few banks, they turned to issuing bonds. This has resulted in many more creditors of various kinds holding claims on sovereign debt in the forms of different debt instruments with different time horizons.

The recent wave of financial crises in emerging markets—Mexico in 1994-1995, Asia in 1997-1998, Russia in 1998, and Argentina in 2001—has exacted a considerable toll in terms of lost output and welfare and at times even posed a threat to the stability of world financial markets. As a result, many policymakers and economists have focused on the lessons to be learned from these experiences—lessons both in how better to prevent crises in the first place and in how to manage crises once they occur.

Since the late 1970s, China has undertaken economic reforms that have liberalized agricultural production, allowed the growth of a dynamic private sector, and gradually opened the economy to international trade and foreign direct investment. As a result, China stands as one of the fastest growing economies in the world.

The Standard & Poor’s (S&P) 500 stock index closed at an all-time high of 1527 on March 24, 2000. Since then, the index has declined by about 28% to 1097 as of May 14, 2002, roughly where it was four years ago.

Bank supervisors engage in extensive monitoring of banking organizations in order to enforce regulations and to guard against systemic risk. In the United States, primary responsibility for monitoring bank holding companies (BHCs) falls to the Federal Reserve.

When it comes to compromise, we can take comfort in the old saying, “half a loaf is better than none.” But when it comes to legislation on deposit insurance reform now before Congress, that old saying takes a new twist: “half a loaf is even better than a whole loaf.”

It is somewhat surprising that house prices in most parts of the nation have stayed high despite the downturn in the economy. As Figure 1 shows, real (inflation-adjusted) house price changes became negative with GDP growth during the last recession in 1991; but this time, they have remained positive and appear to be firm.

Recently, some concerns about a “credit crunch” in the U.S. economy have appeared in the business press. In the commercial paper market, a number of large firms were reportedly unable to borrow from this market, as investors reassessed the credit risk of these firms amid growing accounting concerns.

This Economic Letter summarizes the papers presented at the conference “Macroeconomic Models for Monetary Policy” held at the Federal Reserve Bank of San Francisco on March 1-2, 2002, under the joint sponsorship of the Federal Reserve Bank of San Francisco and the Stanford Institute for Economic Policy Research.

There is little doubt that when central banks, including the Federal Reserve, set interest rates, they do so purposefully, with particular goals and objectives in mind. But what are these goals and objectives? And if the Federal Reserve behaves systematically, what is it systematically responding to?

In recent years, the personal saving rate in the United States has fallen sharply, and it is now at a very low level compared either to U.S. historical experience or to the savings behavior of many other industrialized countries. From 1980 through 1994, the U.S. saving rate averaged 8%; thereafter, it fell steeply, and since mid-2000, with allowance made for the tax rebates that boosted household saving in the months of July, August, and September 2001, it has averaged approximately 1%.

In January 2001, the Congressional Budget Office (CBO) reported that the federal government was projected to run a $313 billion surplus in 2002. Now, just a little over a year later, the CBO’s latest reports indicate a major deterioration in the budget projections.

Are turning points in the economy—recessions and recoveries—hard to predict? Recent experience may not tell us much: although almost no forecaster predicted the onset of the latest U.S. recession, unusual forces may have been at work this time around. But what about more typical recessions? And what about recoveries?

The Twelfth District’s extraordinary expansion ended abruptly in 2001, as the downturn in the information technology (IT) sector and the September 11 terrorist attacks combined to damp employment growth in nearly every District state and end the West’s reign as the fastest growing region in the nation.

The sources of labor productivity growth in the U.S. economy have been the subject of much study. Understanding these sources is important because labor productivity growth is the key to increasing our economic standard of living.

In the U.S., we spent much of last year wondering whether the economy was in recession or simply pausing after years of extraordinary growth. In California, the recession picture was even less clear, with widespread weakness in the San Francisco Bay Area, but more stable conditions in the much larger Southern California economy.

As the U.S. struggles with its first economic slowdown in a decade, so do most of the major industrialized countries. Japan is sliding again into recession, with third quarter GDP growth of -2.2%. Europe also seems to be slowing, with a third quarter growth rate of 0.4% for the euro area as a whole, and -0.6% for Germany in particular.

Financial institutions are in the business of risk management and reallocation, and they have developed sophisticated risk management systems to carry out these tasks. The basic components of a risk management system are identifying and defining the risks the firm is exposed to, assessing their magnitude, mitigating them using a variety of procedures, and setting aside capital for potential losses.

The events of September 11 have had some of their worst economic effects on the airline industry, leading to a dramatic fall-off in passenger demand and substantially higher costs. But even before that day, the industry was facing bad times, with few airlines anticipating profitable performances in 2001. Some have argued that deregulation has contributed to the industry’s problems, and, furthermore, to problems for passengers.

2001

Subprime mortgage lending has grown tremendously since the early 1990s and now constitutes a significant fraction of the overall mortgage market. This Economic Letter defines subprime mortgage lending, describes its growth, and presents evidence on the link between this market and the capital markets. This link should help encourage the flow of funds into subprime lending, thereby encouraging competition in this important market segment.

Financial innovation has greatly changed the business of banking. Instead of just accepting deposits and making loans the old-fashioned way, banks nowadays are increasingly active in lending without putting loans on their balance sheets, through either securitization of their asset portfolio or outright loan sales.

“Runaway” expenditures on health in the United States and what to do about them have been a feature of congressional debate for years. In 1998, the United States spent 13.6% of its GDP on goods and services associated with health care.

This Economic Letter is adapted from remarks by Robert T. Parry, President and CEO of the Federal Reserve Bank of San Francisco, delivered on November 19, 2001, to the 24th Annual Real Estate and Economics Symposium sponsored by U.C. Berkeley’s Fisher Center for Real Estate and Urban Economics.

Financial derivatives have greatly enhanced the range of tools available for managing financial risks. Currently, derivatives are widely used to mitigate and reallocate the financial risk related to changes in interest rates, exchange rates, stock prices, and commodity prices.

Economists and other analysts look for signs of the economy’s current and future performance in many places, including the bond market. One recent signal from that market that may prove useful involves the spread in the yields between junk bonds and other long-term debt instruments.

The Twelfth District includes the nine westernmost states and has some of the nation’s leading technology centers. Over the past several years, robust growth among information technology (IT) firms has fueled gains in output, employment, and earnings and helped the District economy expand more rapidly than the rest of the nation.

In the wake of continued weakness in the Japanese economy and recent market turbulence due to the terrorist attacks in the U.S., the Bank of Japan (BOJ) recently increased the intensity of its quantitative easing program, which it had begun in March of this year. The BOJ initially switched from the usual approach to expansionary monetary policy—namely, a reduction in the target short-term interest rate—to quantitative easing because by that time it had been pursuing a target very close to zero (0.15%).

The banking industry performed exceptionally well during the strong economic expansion of the past five years. Strong demand for loans and banking services and the strong supply of quality customers helped boost bank earnings.

Recession fears greatly intensified after the terrorist attack of September 11, 2001. In a Blue Chip survey of business economists taken one week later, 82% answered yes to the question “Is the U.S. economy currently in a recession?”

During the latter half of the 1990s, productivity grew at almost twice the pace of the preceding ten years. Widely attributed to developments in the information technology sector, this surge in productivity was accompanied by an unemployment rate that dropped to unusually low levels.

With the slowing economy, vacancy rates in commercial real estate markets have risen sharply over the last two quarters. Nowhere is this more evident than in the Twelfth District, where vacancy rates in the key high-tech markets (San Francisco, San Jose, and Seattle) have increased four-fold since the fourth quarter of 2000.

The title of a popular 1987 book by William Greider on the Federal Reserve said it all: Secrets of the Temple conjured up an image of the high priests of monetary policy hidden away behind marble walls in Washington, D. C., making mysterious decisions that affected the lives of all Americans. While the Fed’s policymaking body, the Federal Open Market Committee (FOMC), would eventually release minutes of its meetings, and the Chairman did testify twice a year before Congress and would frequently give public speeches, that image of secrecy was one that central bankers often seemed to enjoy cultivating.

Broadly speaking, the papers at the conference were concerned with modeling the effects of policy in an economy with nominal rigidities—that is, with prices and wages that are relatively inflexible, or “sticky.” One set of papers focused on determining the characteristics that a model economy would require to plausibly reproduce the observed behavior of key macroeconomic variables such as output and inflation, especially in response to a monetary policy shock.

The Federal Reserve System is an important participant in the nation’s payments system—the infrastructure used for transmitting payments among individuals, firms and government entities. For example, according to the Rivlin report of 1998, the twelve Federal Reserve Banks processed about one-third of the estimated 45 billion checks transferred between banks in the United States in 1996.

The banking sector has posted strong growth in labor productivity for almost two decades. The shift in trend productivity growth for banking predates by more than a decade the much-touted New Economy productivity shock of the second half of the 1990s, which is most often associated with advances in information technology (IT).

In the wake of the East Asian, Russian, and Brazilian currency crises of the 1990s, a growing chorus of observers and economists (for example, Radelet and Sachs 1998, and Stiglitz 2000) has argued that an underlying cause of – or at least a contributing factor to – such disruptions is the liberalization of international capital flows, especially when combined with fixed exchange rates. A common policy prescription that follows from this argument is to impose restrictions on capital flows and other international payments with the hope of insulating economies from speculative attacks and thereby creating greater currency stability.

The recent passage of a tax cut package in the U.S. raises an interesting and important question for monetary policy: Will the tax cuts create inflation that the Fed cannot contain? According to conventional wisdom, the answer is “no.” So long as a central bank is independent and well run, it can control inflation, irrespective of the stance of fiscal policy.

This Economic Letter is adapted from several recent presentations by Robert T. Parry, President and Chief Executive Officer of the Federal Reserve Bank of San Francisco, to civic and professional organizations in California.

This Economic Letter summarizes the papers presented at the conference “Asset Prices, Exchange Rates, and Monetary Policy” held at Stanford University on March 2-3, 2001, under the joint sponsorship of the Federal Reserve Bank of San Francisco and the Stanford Institute for Economic Policy Research.

Stock prices have been on an extraordinary ride in the last two and a half years, soaring to phenomenal heights and then plunging at head-spinning rates. At their peaks, the NASDAQ composite and the S&P 500 were up 579% and 233%, respectively, compared to the beginning of 1995.

Controlling inflation is a key concern of central bankers around the world. But how best to control inflation differs across countries according to their individual characteristics; for example, small open economies tend to import more goods as a percentage of GDP than larger, more closed, economies, such as the United States.

On April 26, 2001, Junichiro Koizumi was elected Prime Minister of Japan by the Parliament, winning a popular mandate to reform the ruling Liberal Democratic Party (LDP) and lead the country out of a decade of economic and financial distress. Koizumi is known as a maverick—a title of honor he will richly deserve if his proposal to privatize Japan’s Postal Savings System (PSS) succeeds: It would represent the most significant and difficult structural change in Japanese finance in the postwar period.

The increase in productivity growth rates beginning in the mid-1990s has helped boost economic growth and speed the rate at which living standards rise in the United States. Between 1995 and 2000, productivity growth averaged 2.8%—almost double the rate during the preceding 22 years! This increase in productivity growth is thought by many observers to be associated with the increased importance of information technology (IT), a hypothesis often referred to as the “New Economy” view.

In the past few years, there have been several developments in the field of modeling the credit risk in banks’ commercial loan portfolios. Credit risk is essentially the possibility that a bank’s loan portfolio will lose value if its borrowers become unable to pay back their debts.

Wholesale prices of natural gas and electricity have risen dramatically in the West in recent months. These wholesale price increases are showing through to rates paid by households, particularly in the unregulated retail market for natural gas.

In January 2001, the non-partisan U.S. Congressional Budget Office (2001a) issued updated federal budget projections for fiscal years 2002 through 2011. According to the CBO’s baseline projections, the federal government will accumulate $5.6 trillion in total surpluses over the coming decade.

New financial instruments, new information technologies, and a new regulatory environment have blurred the distinctions between commercial banks and nonbank financial intermediaries in the U.S. in recent years. Furthermore, just as many nonbank financial institutions have increased their use of securitization, commercial banks also have shifted their emphasis from on-balance sheet to off-balance sheet activities (Boyd and Gertler 1994).

After the 1997 balance of payments problems and currency crises that hit Korea, Indonesia, Thailand, and other countries, the stabilization programs supported by the International Monetary Fund (IMF) came under critical fire. At issue was the cost of these programs in terms of forgone output and employment in the countries that adopted them. Stiglitz (2000), for example, argued that “…the IMF’s economic ‘remedies’ often make things worse—turning slowdowns into recessions and recessions into depressions.” Similar statements by other leading economists have been commonplace.

The causes of the currency crises in emerging markets during the late 1990s have been the subject of much debate—especially considering that, before the crises, many of the Asian countries involved tended to have balanced budgets and generally sound macroeconomic performance. Some observers argue that the generally favorable macroeconomic conditions indicate that the crises were not caused by incompatibility between fiscal and monetary policies and exchange rate pegs, but rather by the unexpected and self-fulfilling panics of foreign investors.

In January of 2001, overseas financial markets saw the re-emergence of the “Japan premium,” a term used to describe the extra interest charged on offshore loans to Japanese banks relative to similarly risky banks from other developed countries. So far, the magnitude of the Japan premium has been small, never exceeding 0.05% and 0.07%, depending on the bank examined.

How quickly does the Fed adjust monetary policy in response to developments in the economy? A common view among economists is that the Fed changes the short-term policy interest rate at a very sluggish pace over several quarters.

Natural gas prices have risen significantly in recent months, surpassing nearly all forecasts. In December, the spot price at the Henry Hub—the benchmark for U.S. natural gas prices—averaged $6.31 per million British Thermal Units (MMbtu), more than three times the average spot price one year earlier.

By the beginning of the 1980s, double-digit rates of inflation had become so pervasive among industrialized economies that they were viewed as a major deterrent to global economic growth. Since then, an explicit policy goal of low inflation has become a mantra for policymakers, and many countries, such as the U.K., New Zealand, Australia, Japan, Sweden, and the eleven countries under the European Central Bank (ECB), have enacted fundamental reforms to achieve that goal.

Since 1994, depository institutions have been able to lower required reserves without affecting customer liquidity by periodically reclassifying balances from retail transactions deposits into savings accounts. This practice, known as “sweeping,” has grown rapidly in the last six years, and, as a result, reserve requirements as a percentage of total liquid deposits have fallen dramatically.

2000

More than three years have passed since the collapse of the Thai baht triggered a wave of currency and financial crises in East Asia. After experiencing sharp economic contraction in 1998, East Asian economies have rebounded strongly, buttressed by rapid growth in their exports to the United States.

Over the last year the U.S. current account deficit has reached unprecedented levels. Figure 1 illustrates this by charting the falling trajectory of the current account balance, which essentially measures net exports of goods and services plus net income received from foreign investments.

The year 2000 has been sobering for investors in firms that have had initial public offerings, or IPOs, in recent years. Those investors include, of course, employees holding stocks and stock options in these firms.

During the 1990s, the global economy experienced a major increase in trade and cross-border business activity, which created a greater demand for international financial services. Consequently, many commercial banks increased their cross-border activities, both to service their domestic customers and to gain new foreign customers.

Productivity growth in the U.S. has picked up noticeably in recent years. From 1996 to 1999, average labor productivity, or ALP, in the private, nonfarm U.S. economy grew at a 2.8% annual rate, more than twice the rate that prevailed between 1980 and 1995.

After more than two years of weakness, exports from the West have begun to rebound. The recent pickup is due in large part to the economic resurgence of a number of trading partners of western states and to rapid growth in world demand for a variety of high-tech manufactured products.

After several years of rising to ever greater heights, bank profits took a dive in the second quarter, with return on assets (ROA) falling to 1.0%, the lowest it has been since 1992 (see Table “Banks Headquartered by Region”). The reason: poor performance at large banks, which had an ROA of 0.94%.

This Economic Letter is adapted from a presentation by Robert T. Parry, President and CEO of the Federal Reserve Bank of San Francisco, to the conference “Recent Developments in Financial Systems and Their Challenges for Economic Policy” sponsored by the Bank for International Settlements and The Deutsche Bundesbank September 29, 2000, in Frankfurt, Germany.

The currency crises of the 1990s appeared to reinforce the view that, in the long run, all currency pegs are unsustainable. And yet, pegged regimes maintain their attraction. For example, Calvo and Reinhart (2000) find evidence that many countries intervene to smooth fluctuations in the exchange rate even while they claim to be floating.

It is by now conventional wisdom that the economic expansion during the 1990s was both broad and deep, reaching Americans of all races, ethnicities, and income levels. However, this Economic Letter summarizes recent research by Burkhauser, Daly, and Houtenville (forthcoming and 2000, hereafter BDH) which shows that for the nearly 10% of the working-age population with disabilities, strong economic growth during the 1990s did not produce higher rates of employment or rapid income gains.

The San Francisco Bay Area is notable for its concentration of high-tech firms. The Bay Area also has experienced a sharp appreciation in house prices in recent years. Part of the explanation for the soaring house prices may lie in the so-called “wealth effect.”

In the wake of the large number of international financial crises that occurred in the 1990s, several proposals have been put forth to reform the “international financial architecture,” that is, the institutional features that characterize the international monetary system. These proposals aim to make the system less prone to financial crises in the future.

Although by most measures the California economy has been outperforming the U.S. economy for nearly five years, a number of statistics on family income suggest that Californians are losing ground relative to others in the U.S. Data on income growth show that while median family income outside of California grew by more than 8% between 1989 and 1998, median family income in California declined by 4%.

Twenty years ago, the policy problem facing many central banks was obvious–inflation was too high and needed to be reduced. Identifying the problem did not mean it was easy to solve. Debate centered on the potential real output and unemployment costs of reducing inflation, on whether a gradual disinflation or a more rapid one would be least costly, and on how central banks could credibly commit to carrying through a disinflation once begun.

Internet-related technology is part of many industries, including the residential mortgage business. At first, e-commerce innovations mainly involved the business-to-consumer (B2C) segment in electronically soliciting and submitting mortgage applications. More recently, business-to-business (B2B) mortgage transactions have come into the e-commerce world.

Capital flows between countries can yield significant benefits. They allow investors to diversify their risks and increase returns, and they allow residents of recipient countries to finance rapid rates of investment and economic growth, as well as to increase consumption.

Over the past year, the Federal Reserve has been raising short-term interest rates. These rate hikes are designed to prevent inflation from trending upward from the low levels enjoyed by U.S. consumers over the past several years.

Since the 1980s, U.S. stock markets have soared, and stock prices now are at levels that were unimaginable before the boom started. There has been no shortage of speculation about the reasons for this performance.

Since the early 1990s, rising unemployment, price deflation, sluggish growth, and even recession have beleaguered Japan. The country’s central bank, the Bank of Japan (BOJ), has responded by lowering interest rates to stimulate demand.

Although currency crises may not be predictable, what is predictable is that after each one there will be calls to reform the “international financial architecture.” One proposal currently making the rounds is to stabilize capital flows with policies that either encourage “long-term” capital flows or discourage “short-term” capital flows.

This Economic Letter is adapted from a keynote address delivered by Robert T. Parry, President and CEO of the Federal Reserve Bank of San Francisco, to the 28th Annual Northern California Financial Planning Conference in San Francisco on May 9, 2000.

The debate over dollarization has arisen in several countries, but it is often at its most fervent in Argentina. In that country, a decade of currency board experience with dollar-peso convertibility has brought the economy as close to being dollarized as one can be without going all the way.

From January 1995 through the third week of April 2000, the Dow Jones Industrial Average (DJIA) advanced a respectable 184%. Even though this venerable index has included tech firms over the last few years–most recently Intel and Microsoft in 1999–it still is taken by many to represent the industrial heavyweights of the so-called old economy.

A cursory look at the data on bank profitability suggests that, since the end of 1995, small banks headquartered in California have been significantly less profitable than medium-sized banks in the state. In addition, it appears that small bank performance in California lags that of small banks in the rest of the country.

This Economic Letter summarizes the papers presented at the conference “Structural Change and Monetary Policy” held in San Francisco on March 3-4, 2000, under the joint sponsorship of the Federal Reserve Bank of San Francisco and Stanford University’s Stanford Institute for Economic Policy Research.

This Economic Letter is adapted from a speech delivered by Robert T. Parry, President and Chief Executive Officer of the Federal Reserve Bank of San Francisco at the European Banking and Financial Forum in Prague, the Czech Republic, on March 29, 2000, in a panel discussing financial globalization, international financial institutions, and developments in the financial sectors of post-communist countries.

The Japanese government and the Bank of Japan (BOJ) are both considering the merits of conducting that nation’s monetary policy by pursuing an explicit inflation target. However, they seem to view inflation targeting as a means to quite different ends, which leads them to different conclusions about the proper timetable for a move towards such a regime.

After more than two decades of debate, full affiliation of commercial banking with other financial services became a reality in March 2000. The Gramm-Leach-Bliley Act (GLBA), signed into law last November, authorized the certification of financial holding companies, the st